STATEMENT OF ADDITIONAL INFORMATION

                               SCHWAB INVESTMENTS

SCHWAB SHORT-TERM BOND MARKET              SCHWAB CALIFORNIA SHORT/INTERMEDIAT
FUND(TM)                                   TAX-FREE BOND FUND(TM)
SCHWAB TOTAL BOND MARKET FUND(TM)          SCHWAB CALIFORNIA LONG-TERM TAX-FRE
SCHWAB SHORT/INTERMEDIATE TAX-FREE         BOND FUND(TM)
BOND FUND(TM)                              SCHWAB YIELDPLUS FUND(R)
SCHWAB LONG-TERM TAX-FREE BOND             SCHWAB GNMA FUND(TM)
FUND(TM)

                                NOVEMBER 15, 2003

                            AS AMENDED MARCH 5, 2004

The Statement of Additional Information (SAI) is not a prospectus. It should be
read in conjunction with the funds' prospectuses dated November 15, 2003 (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.

                                TABLE OF CONTENTS



                                                                                             Page
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INVESTMENT OBJECTIVES, STRATEGIES, SECURITIES, RISKS AND
LIMITATIONS.....................................................................                2
MANAGEMENT OF THE FUNDS.........................................................               40
DESCRIPTION OF PROXY VOTING POLICY AND PROCEDURES...............................               55
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES.............................               60
INVESTMENT ADVISORY AND OTHER SERVICES..........................................               61
BROKERAGE ALLOCATION AND OTHER PRACTICES........................................               64
DESCRIPTION OF THE TRUST........................................................               67
PURCHASE, REDEMPTION, DELIVERY OF SHAREHOLDER DOCUMENTS
AND PRICING OF SHARES...........................................................               68
TAXATION........................................................................               71
CALCULATION OF PERFORMANCE DATA.................................................               74
APPENDIX - RATINGS OF INVESTMENT SECURITIES.....................................               81


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            INVESTMENT OBJECTIVES, STRATEGIES, SECURITIES, RISKS AND
                                  LIMITATIONS

                              INVESTMENT OBJECTIVES

SCHWAB SHORT-TERM BOND MARKET FUND(TM)
SCHWAB TOTAL BOND MARKET FUND(TM)

Each fund's investment objective is to attempt to provide a high level of
current income consistent with preservation of capital by seeking to track the
investment results of a particular bond index through the use of an indexing
strategy.

The 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(TM)
SCHWAB LONG-TERM TAX-FREE BOND FUND(TM)
SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM)
SCHWAB CALIFORNIA LONG-TERM TAX-FREE BOND FUND(TM)

Schwab Short/Intermediate Tax-Free Bond Fund and Schwab Long-Term Tax-Free Bond
Fund's investment objective is to seek a high level of current income that is
exempt from federal income tax, consistent with preservation of capital.

Schwab California Short/Intermediate Tax-Free Bond Fund and Schwab California
Long-Term Tax-Free Bond Fund's investment objective is to seek a high level of
current income that is exempt from federal income and State of California
personal income taxes, consistent with preservation of capital.

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.

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SCHWAB GNMA FUND(TM)

The fund's investment objective is to seek high current income consistent with
preservation of capital.

                         CHANGE OF INVESTMENT OBJECTIVE

Each fund's investment objective may be changed by vote of a majority of its
outstanding voting shares. A majority vote of outstanding securities of a fund
means the vote, at an annual or a special meeting of shareholders of a fund
where (a) of 67% or more of the voting securities present at the meeting, if the
shareholders of more than 50% of the outstanding securities of a fund are
present or represented by proxy, or (b) of more than 50% of the outstanding
voting securities of a fund, whichever is less.

There is no guarantee that a fund will achieve its investment objective.

                CHANGE TO 80% INVESTMENT POLICY OF CERTAIN FUNDS

Schwab Short-Term Bond Market Fund(TM), Schwab Total Bond Market Fund(TM)
(collectively "the Bond Funds") will each, under normal circumstances, invest at
least 80% of its 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(TM), Schwab Long-Term Tax-Free
Bond Fund(TM), Schwab California Short/Intermediate Tax-Free Bond Fund(TM),
Schwab California Long-Term Tax-Free Bond Fund(TM) (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 exempt 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 exempt 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% of its total assets in
municipal securities financing similar projects.

Schwab GNMA Fund will, under normal circumstances, invest at least 80% of its
assets in securities issued by GNMA. The fund will notify its shareholders at
least 60 days before changing this policy. For purposes of this policy, assets
mean net assets plus the amount of any borrowings for investment purposes.

                       INVESTMENTS, RISKS AND LIMITATIONS

The following descriptions of investment securities, risks and limitations
supplement those set forth in the prospectus and may be changed without
shareholder approval unless otherwise noted. Not all investment securities or
techniques discussed below are eligible investments for each fund. Each fund
will invest in securities or engage in techniques that are intended to help
achieve its investment objective.

BANKERS' ACCEPTANCES or notes are credit instruments evidencing a bank's
obligation to pay a

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draft drawn on it by a customer. These instruments reflect the obligation both
of the bank and of the drawer to pay the full amount of the instrument upon
maturity. A fund will invest only in bankers' acceptances of banks that have
capital, surplus and undivided profits in excess of $100 million.

BOND SUBSTITUTION is a strategy whereby a fund may, from time to time,
substitute one type of investment-grade bond for another. This means that, as an
example, a fund may have a higher weighting in corporate bonds and a lower
weighting in U.S. Treasury securities than its index in order to increase
income. This particular substitution - a corporate bond substitution - may
increase a fund's credit risk, although this may be mitigated through increased
diversification in the corporate sector of the bond market. The Tax-Free Bond
Funds do not utilize the strategy of bond substitution.

BORROWING may subject a fund to interest costs, which may exceed the interest
received on the securities purchased with the borrowed funds. A fund normally
may borrow at times to meet redemption requests rather than sell portfolio
securities to raise the necessary cash. Borrowing can involve leveraging when
securities are purchased with the borrowed money. To avoid this, a fund will
earmark or segregate assets to cover such borrowings in accordance with
positions of the Securities and Exchange Commission (the SEC). Each fund may
borrow money from banks and make other investments or engage in other
transactions permissible under the Investment Company Act of 1940, (the 1940
Act) which may be considered a borrowing (such as mortgage dollar rolls and
reverse repurchase agreements).

Each fund may establish lines-of-credit (lines) with certain banks by which it
may borrow funds for temporary or emergency purposes. A borrowing is presumed to
be for temporary or emergency purposes if it is repaid by a fund within 60 days
and is not extended or renewed. Each fund intends to use the lines to meet large
or unexpected redemptions that would otherwise force a fund to liquidate
securities under circumstances which are unfavorable to the fund's remaining
shareholders. Each fund will pay a fee to the bank for using the lines.

CALIFORNIA MUNICIPAL SECURITIES are municipal securities issued by or on behalf
of, the State of California, or its counties, municipalities, authorities or
other subdivisions. The Schwab California Short/Intermediate Tax-Free Bond
Fund(TM) and Schwab California Long-Term Tax-Free Bond Fund(TM) are
state-specific municipal funds that invest substantially all of their assets in
California Municipal Securities. The other funds also may invest a portion of
their assets in California Municipal Securities but will not invest
substantially all of their assets in such securities.

By many measures the State of California (sometimes referred to herein as the
"State") is both sizable and diverse. California is the largest state in the
union and among the largest economies in the world. The State's geography and
position on the edge of the Pacific Rim lends itself to a vast array of economic
activity. Major components of the State's economy include high technology,
trade, entertainment, agriculture, tourism, construction and services. While
this diverse economic base is a fundamental strength for the State and supports
its creditworthiness, it also makes the State vulnerable to challenges stemming
from many sources including economic trends, legislative and legal actions as
well as shifts in political views.

Within the State's borders are areas of geological instability that have in the
past experienced major earthquakes resulting in significant economic damage. It
is impossible to predict the time, magnitude or location of a major earthquake
or its effect on the California economy. In January 1994, a major earthquake
struck the Los Angeles area, causing significant damage in a four

                                                                               4


county area. The possibility exists that another such earthquake could create a
major dislocation of the California economy and significantly affect State and
local government budgets.

Since early 2001, the State has faced severe financial challenges, which may
continue for several years. The recession in 2001 and sluggish economic growth
in 2002 and 2003 (with greatest impacts in the high technology, internet, and
telecommunications sectors, especially in Northern California, and the attendant
adverse impact on stock market valuations), led to a substantial decline in
General Fund revenues that was not adequately addressed by either a
proportionate cut in State spending or increase in taxes or other revenues. In
January 2003, Governor Davis projected that these imbalances would lead to a
budget gap of more than $34 billion through the end of fiscal 2004 absent
corrective action.

While the Legislature passed budget adjustment legislation in March and April
2003 totaling about $10.4 billion in spending reductions, deferrals and funding
transfers ($5.1 billion for 2002-03 and $5.2 billion for 2003-04), in May,
Governor Davis projected that the cumulative budget gap had nonetheless grown to
$38.2 billion. After much debate, on August 2, 2003, Governor Davis signed the
annual Budget Act for fiscal 2004-05. The adopted budget is dependant on
numerous assumptions and contingencies including issuance of two bond
financings, one to fund the State's pension obligation ($1.9 billion) and the
other, referred to as the fiscal recovery bonds, to cover some of the remaining
budget gap ($10.7 billion) as well as enactment of structural reforms to
eliminate an estimated $7.9 billion structural deficit for fiscal 2004. The
State is appealing a trial court's failure to validate the pension obligation
bonds. Separately, a legal advocacy institution has filed an action asserting
that issuance of the fiscal recovery bonds would violate the State's
constitutional debt-limit provision. While the State Attorney General disagrees
with this argument the ability of the State to issue to the bonds will depend on
the outcome of the pending legal action.

In addition to the known budgetary issues, on October 7, 2003 a special election
was held that recalled Governor Gray Davis and replaced him with Arnold
Schwarzenegger. Governor-elect Schwarzenegger is in the process of evaluating
the State's financial condition and as a result may propose mid-year legislation
or take executive actions that could affect the State's receipts, disbursements
and proposed borrowing during the current fiscal year. If the Governor-elect
repeals the recent reinstatement of the Vehicle License Fee, he and the
legislature will have to find approximately $4 billion in expenditure cuts to
prevent the repeal from adversely affecting local governments throughout the
State.

It cannot be predicted what actions will be taken in the future by the State
Legislature and the Governor to deal with changing State revenues and
expenditures. The State budget will be affected by national and State economic
conditions and other factors.

As of October 14, 2003, the State's general obligation bonds were rated A3 by
Moody's, BBB by Standard & Poor's, and A by Fitch Ratings. In August 2003,
Moody's lowered its rating to A3 from A2. In July 2003, Standard and Poor's
lowered its rating to BBB from A. Fitch similarly lowered its rating to A from
AA and is keeping the rating on its watch list for possible further downgrading
due to recessionary conditions and an unprecedented drop in personal income tax
receipts which it expects to continue into 2003-04. It is not presently possible
to determine whether, or the extent to which, Moody's, Standard and Poor's, 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.

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The primary units of local government in California are the counties, ranging in
population from 1,200 (Alpine) to approximately 10,000,000 (Los Angeles). The
fiscal condition of local governments has been constrained since the enactment
of "Proposition 13" in 1978 and later constitutional amendments, which reduced
and limited the future growth of property taxes and limited the ability of local
governments to impose "special taxes" (those devoted to a specific purpose)
without two-thirds voter approval. Proposition 218, another initiative
constitutional amendment enacted in 1996, further limited the ability of local
governments to impose or raise various taxes, fees, charges and assessments
without voter approval. Counties, in particular, have had fewer options to raise
revenues than many other local government entities, and have been required to
maintain many services. Some local governments in California have experienced
notable financial difficulties, including Los Angeles County and Orange County,
and there is no assurance that any California issuer will make full or timely
payments of principal or interest or remain solvent.

The State is subject to an annual appropriations limit imposed by Article XIII B
of the State Constitution (the "Appropriations Limit"). The Appropriations Limit
does not restrict appropriations to pay debt service on voter-authorized bonds.
Article XIII B prohibits the State from spending "appropriations subject to
limitation" in excess of the Appropriations Limit. On November 8, 1988, voters
of the State approved Proposition 98, a combined initiative constitutional
amendment that changed State funding of public education below the university
level and the operation of the State appropriations funding, primarily by
guaranteeing K-14 schools a minimum share of General Fund revenues. Proposition
98 also contains provisions transferring certain State tax revenues in excess of
the Article XIII B limit to K-14 schools.

Because of the complexities of Article XIII B, the ambiguities and possible
inconsistencies in its terms, the applicability of its exceptions and exemptions
and the impossibility of predicting future appropriations, the impact of this or
related legislation cannot be predicted.

Other Constitutional amendments affecting State and local taxes and
appropriations have been proposed from time to time. If any such initiatives are
adopted, the State could be pressured to provide additional financial assistance
to local Governments or appropriate revenues as mandated by such initiatives.
Propositions such as Proposition 98 and others that may be adopted in the
future, may place increasing pressure on the State's budget over future years,
potentially reducing resources available for other State programs, especially to
the extent the Article XIII B spending limit would restrain the State's ability
to fund such other programs by raising taxes.

The State of California is a party to numerous legal proceedings, many of which
normally occur in governmental operations. In addition, the State is involved in
certain other legal proceedings that, if decided against the State might require
the State to make significant future expenditures or impair future revenue
sources. Because of the prospective nature of these proceedings, it is not
presently possible to predict the outcome of such litigation or estimate the
potential impact on the ability of the State to pay debt service costs on its
obligations.

CAPITAL SECURITIES are certain subordinated bank securities. They are bank
obligations that fall below senior unsecured debt and deposits in liquidation. A
bank's capital comprises share capital reserves and a series of hybrid
instruments also know as capital securities. These securities are used to
augment equity Tier 1 and are usually in the form of subordinated debt. A
capital security has to adhere to supervisory guidelines concerning its
characteristics such as amount, maturity, subordination and deferral language in
order to count as capital. Regulators across the world tend to look toward the
Bank for International Settlements ("BIS") for guidance in setting the capital

                                                                               6


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 fund
has identified mortgage-backed securities issued by private lenders and not
guaranteed by U.S. government agencies or instrumentalities as a separate
industry for purposes of a fund's concentration policy. Each of the Tax-Free
Bond Funds may invest more than 25% of its total assets in municipal securities
financing similar project, which may make them more sensitive to certain adverse
economic, business or political developments affecting issuers of such
securities.

CONVERTIBLE SECURITIES are typically preferred stock or bonds that are
exchangeable for a specific number of another form of security (usually the
issuer's common stock) at a specified price or ratio. A corporation may issue a
convertible security that is subject to redemption after a specified date and
usually under certain circumstances. A holder of a convertible security that is
called for redemption would be required to tender it for redemption to the
issuer, convert it to the underlying common stock or sell it to a third party.
Convertible bonds typically pay a lower interest rate than nonconvertible bonds
of the same quality and maturity, because of the convertible feature. This
structure allows the holder of the convertible bond to participate in share
price movements in the company's common stock. The actual return on a
convertible bond may exceed its stated yield if the company's common stock
appreciates in value and the option to convert to common shares becomes more
valuable.

Convertible securities typically trade at prices above their conversion value,
which is the current market value of the common stock received upon conversion,
because of their higher yield potential than the underlying common stock. The
difference between the conversion value and the price of a convertible security
will vary depending on the value of the underlying common stock and interest
rates. When the underlying value of the common stocks decline, the price of the
issuer's convertible securities will tend not to fall as much because the
convertible security's income potential will act as a price support. While the
value of a convertible security also tends to rise when the underlying common
stock value rises, it will not rise as much because their conversion value is
more narrow. The value of convertible securities also is affected by changes in
interest rates. For example, when interest rates fall, the value of convertible
securities may rise because of their fixed income component. The Tax-Free Bond
Funds do not invest in convertible securities.

CREDIT DEFAULT SWAPS may be entered into for investment purposes. As the seller
in a credit

                                                                               7


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 in its portfolio, in which case a
fund would function as the counterparty referenced in the preceding paragraph.
This would involve the risk that the investment may expire worthless and would
only generate income in the event of an actual default by the issuer of the
underlying obligation (as opposed to a credit downgrade or other indication of
financial instability). It would also involve credit risk - that the seller may
fail to satisfy its payment obligations to a fund in the event of a default. The
Tax-Free Bond Funds do not invest in credit default swaps.

CREDIT AND LIQUIDITY SUPPORTS may be employed by issuers or a fund to reduce the
credit risk of their securities. Credit supports include letters of credit,
insurance, total return and credit swap agreements and guarantees provided by
foreign and domestic entities. Liquidity supports include puts, demand features,
and lines of credit. Most of these arrangements move the credit risk of an
investment from the issuer of the security to the support provider. Changes in
the credit quality of a support provider could cause losses to a fund.

DEBT SECURITIES are obligations issued by domestic and foreign entities,
including governments and corporations, in order to raise money. They are
basically "IOUs," but are commonly referred to as bonds or money market
securities. These securities normally require the issuer to pay a fixed,
variable or floating rate of interest on the amount of money borrowed (the
"principal") until it is paid back upon maturity.

Debt securities experience price changes when interest rates change. For
example, when interest rates fall, the prices of debt securities generally rise.
Also, issuers tend to pre-pay their outstanding debts and issue new ones paying
lower interest rates. This is especially true for bonds with sinking fund
provisions, which commit the issuer to set aside a certain amount of money to
cover timely repayment of principal and typically allow the issuer to annually
repurchase certain of its outstanding bonds from the open market or at a pre-set
call price.

Conversely, in a rising interest rate environment, prepayment on outstanding
debt securities generally will not occur. This is known as extension risk and
may cause the value of debt securities to depreciate as a result of the higher
market interest rates. Typically, longer-maturity securities react to interest
rate changes more severely than shorter-term securities (all things being
equal), but generally offer greater rates of interest.

Debt securities also are subject to the risk that the issuers will not make
timely interest and/or principal payments or fail to make them at all. This is
called credit risk. Corporate debt securities (bonds) tend to have higher credit
risk generally than U.S. government debt securities. Debt securities also may be
subject to price volatility due to market perception of future interest rates,
the creditworthiness of the issuer and general market liquidity (market risk).
Investment-grade debt securities are considered medium- or/and high-quality
securities, although some still possess varying degrees of speculative
characteristics and risks. Debt securities rated below

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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 are receipts representing ownership of shares of a
foreign-based issuer held in trust by a bank or similar financial institution.
These securities are designed for U.S. and European securities markets as
alternatives to purchasing underlying securities in their corresponding national
markets and currencies. Depositary receipts can be sponsored or unsponsored.
Sponsored depositary receipts are certificates in which a bank or financial
institution participates with a custodian. Issuers of unsponsored depositary
receipts are not contractually obligated to disclose material information in the
United States. Therefore, there may not be a correlation between such
information and the market value of an unsponsored depositary receipt. The
Tax-Free Bond Funds do not invest in depositary receipts.

DERIVATIVE INSTRUMENTS are commonly defined to include securities or contracts
whose values depend on (or "derive" from) the value of one or more other assets
such as securities, currencies, or commodities. These "other assets" are
commonly referred to as "underlying assets."

A derivative instrument generally consists of, is based upon, or exhibits
characteristics similar to options or forward contracts. Options and forward
contracts are considered to be the basic "building blocks" of derivatives. For
example, forward-based derivatives include forward contracts, as well as
exchange-traded futures. Option-based derivatives include privately negotiated,
over-the-counter (OTC) options (including caps, floors, collars, and options on
forward and swap contracts) and exchange-traded options on futures. Diverse
types of

                                                                               9


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, the YieldPlus Fund and the GNMA Fund are diversified
mutual funds.

The Tax-Free Bond Funds are non-diversified mutual funds, which means that each
of the funds may invest in the securities of a limited number of issuers. As a
result, the performance of a particular investment or small group of investments
may affect a Tax-Free Bond Fund's performance more than if the fund were
diversified.

DURATION was developed as a more precise alternative to the concept of
"maturity." Traditionally, a debt obligation's maturity has been used as a proxy
for the sensitivity of the security's price to changes in interest rates (which
is the "interest rate risk" or "volatility" of the security). However, maturity
measures only the time until a debt obligation provides its final payment,
taking no account of the pattern of the security's payments prior to maturity.
In contrast, duration incorporates a bond's yield, coupon interest payments,
final maturity, call and put features and prepayment exposure into one measure.
Duration is the magnitude of the change in the price of a bond relative to a
given change in market interest rates. Duration management is one of the
fundamental tools used by the investment adviser. 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.

                                                                              10


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 are fixed income securities for which the return of principal
and payment of interest is contingent on the non-occurrence of a specific
"trigger" event, such as a hurricane, earthquake, or other physical or
weather-related phenomenon. Some event-linked bonds are commonly referred to as
"catastrophe bonds." If a trigger event occurs, a fund may lose a portion or all
of its principal invested in the bond. Event-linked bonds often provide for an
extension of maturity to process and audit loss claims where a trigger event
has, or possibly has, occurred. An extension of maturity may increase
volatility. Event-linked bonds may also expose a fund to certain unanticipated
risks including credit risk, adverse regulatory or jurisdictional
interpretations, and adverse tax consequences. Event-linked bonds may also be
subject to liquidity risk. The Tax-Free Bond Funds do not invest in event-linked
bonds.

FOREIGN CURRENCY TRANSACTIONS may occur in order to protect against uncertainty
in the level of future foreign exchange rates in the purchase and sale of
securities. All funds that may invest in foreign currency-denominated securities
also may purchase and sell foreign currency options and foreign currency futures
contracts and related options and may engage in foreign currency transactions
either on a spot (cash) basis at the rate prevailing in the currency exchange
market at the time or through forward currency contracts ("forwards") with terms
generally of less than one year.

A fund may also use foreign currency options and foreign currency forward
contracts to increase exposure to a foreign currency or to shift exposure to
foreign currency fluctuations from one country to another. The fund will earmark
or segregate assets for any open positions in forwards used for non-hedging
purposes and mark to market daily as may be required under the federal
securities laws.

A forward involves an obligation to purchase or sell a specific currency at a
future date, which may be any fixed number of days from the date of the contract
agreed upon by the parties, at a price set at the time of the contract. These
contracts may be bought or sold to protect a fund against a possible loss
resulting from an adverse change in the relationship between foreign currencies
and the U.S. dollar or to increase exposure to a particular foreign currency.
Many foreign securities markets do not settle trades within a time frame that
would be considered customary in the U.S. stock market. Therefore, a fund may
engage in forward foreign currency exchange contracts in order to secure
exchange rates for fund securities purchased or sold, but awaiting settlement.
These transactions do not seek to eliminate any fluctuations in the underlying
prices of the securities involved. Instead, the transactions simply establish a
rate of exchange that can be expected when a fund settles its securities
transactions in the future. Forwards involve certain risks. For example, if the
counterparties to the contracts are unable to

                                                                              11


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 in foreign
currency transactions.

Forwards will be used primarily to adjust the foreign exchange exposure of a
fund with a view to protecting the outlook, and a fund might be expected to
enter into such contracts under the following circumstances:

LOCK IN: When the investment adviser desires to lock in the U.S. dollar price on
the purchase or sale of a security denominated in a foreign currency.

CROSS HEDGE: If a particular currency is expected to decrease against another
currency. A fund may sell the currency expected to decrease and purchase a
currency which is expected to increase against the currency sold in an amount
approximately equal to some or all of the fund's portfolio holdings denominated
in the currency sold.

DIRECT HEDGE: If the investment adviser wants to eliminate substantially all of
the risk of owning a particular currency, and/or if the investment adviser
thinks that a fund can benefit from price appreciation in a given country's
bonds but does not want to hold the currency, it may employ a direct hedge back
into the U.S. dollar. In either case, a fund would enter into a forward contract
to sell the currency in which a portfolio security is denominated and purchase
U.S. dollars at an exchange rate established at the time it initiated the
contract. The cost of the direct hedge transaction may offset most, if not all,
of the yield advantage offered by the foreign security, but a fund would benefit
from an increase in value of the bond.

                                                                              12


PROXY HEDGE: The investment adviser might choose to use a proxy hedge, which may
be less costly than a direct hedge. In this case, a fund, having purchased a
security, will sell a currency whose value is believed to be closely linked to
the currency in which the security is denominated. Interest rates prevailing in
the country whose currency was sold would be expected to be closer to those in
the U.S. and lower than those of securities denominated in the currency of the
original holding. This type of hedging entails greater risk than a direct hedge
because it is dependent on a stable relationship between the two currencies
paired as proxies and the relationships can be very unstable at times.

COSTS OF HEDGING: When a fund purchases a foreign bond with a higher interest
rate than is available on U.S. bonds of a similar maturity. The additional yield
on the foreign bond could be substantially reduced or lost if the fund were to
enter into a direct hedge by selling the foreign currency and purchasing the
U.S. dollar. This is what is known as the "cost" of hedging. Proxy hedging
attempts to reduce this cost through an indirect hedge back to the U.S. dollar.

It is important to note that hedging costs are treated as capital transactions
and are not, therefore, deducted from a fund's dividend distribution and are not
reflected in its yield. Instead such costs will, over time, be reflected in a
fund's net asset value per share.

Tax consequences of hedging under applicable tax law, may require a fund to
limit its gain from hedging in foreign currency forwards, futures, and options.
Although each fund is expected to comply with such limits, the extent to which
these limits apply is subject to tax regulations as yet unissued. Hedging may
also result in the application of the mark-to-market and straddle provisions of
the Internal Revenue Code. Those provisions could result in an increase (or
decrease) in the amount of taxable dividends paid by a fund and could affect
whether dividends paid by a fund is classified as capital gains or ordinary
income.

FOREIGN SECURITIES involve additional risks, including foreign currency exchange
rate risks, because they are issued by foreign entities, including foreign
governments, banks, corporations or because they are traded principally
overseas. Foreign securities in which a fund may invest include foreign entities
that are not subject to uniform accounting, auditing and financial reporting
standards, practices and requirements comparable to those applicable to U.S.
corporations. In addition, there may be less publicly available information
about foreign entities. Foreign economic, political and legal developments, as
well as fluctuating foreign currency exchange rates and withholding taxes, could
have more dramatic effects on the value of foreign securities. For example,
conditions within and around foreign countries, such as the possibility of
expropriation or confiscatory taxation, political or social instability,
diplomatic developments, change of government or war could affect the value of
foreign investments. Moreover, individual foreign economies may differ favorably
or unfavorably from the U.S. economy in such respects as growth of gross
national product, rate of inflation, capital reinvestment, resource
self-sufficiency and balance of payments position.

Foreign securities typically have less volume and are generally less liquid and
more volatile than securities of U.S. companies. Fixed commissions on foreign
securities exchanges are generally higher than negotiated commissions on U.S.
exchanges, although a fund will endeavor to achieve the most favorable overall
results on portfolio transactions. There is generally less government
supervision and regulation of foreign securities exchanges, brokers, dealers and
listed companies than in the United States, thus increasing the risk of delayed
settlements of portfolio transactions or loss of certificates for portfolio
securities. There may be difficulties in obtaining or enforcing judgments
against foreign issuers as well. These factors and others may increase the risks
with respect to the liquidity of a fund, and its ability to meet a large number
of shareholder redemption requests.

                                                                              13


Foreign markets also have different clearance and settlement procedures and, in
certain markets, there have been times when settlements have been unable to keep
pace with the volume of securities transactions, making it difficult to conduct
such transactions. Such delays in settlement could result in temporary periods
when a portion of the assets of a fund is uninvested and no return is earned
thereon. The inability to make intended security purchases due to settlement
problems could cause a fund to miss attractive investment opportunities. Losses
to a fund arising out of the inability to fulfill a contract to sell such
securities also could result in potential liability for a fund.

Investments in the securities of foreign issuers may be made and held in foreign
currencies. In addition, a fund may hold cash in foreign currencies. These
investments may be affected favorably or unfavorably by changes in currency
rates and in exchange control regulations, and may cause a fund to incur costs
in connection with conversions between various currencies. The rate of exchange
between the U.S. dollar and other currencies is determined by the forces of
supply and demand in the foreign exchange market as well as by political and
economic factors. Changes in the foreign currency exchange rates also may affect
the value of dividends and interest earned, gains and losses realized on the
sale of securities, and net investment income and gains, if any, to be
distributed to shareholders by a fund. The Tax-Free Bond Funds do not invest in
Foreign Securities.

FORWARD CONTRACTS are sales contracts between a buyer (holding the "long"
position and the seller (holding the "short" position) for an asset with
delivery deferred to a future date. The buyer agrees to pay a fixed price at the
agreed future date and the seller agrees to deliver the asset. The seller hopes
that the market price on the delivery date is less than the agreed upon price,
while the buyer hopes for the contrary. The change in value of a forward-based
derivative generally is roughly proportional to the change in value of the
underlying asset.

FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS involve the purchase or sale of
foreign currency at an established exchange rate, but with payment and delivery
at a specified future time. Many foreign securities markets do not settle trades
within a time frame that would be considered customary in the U.S. stock market.
Therefore, a fund may engage in forward foreign currency exchange contracts in
order to secure exchange rates for portfolio securities purchased or sold, but
awaiting settlement. These transactions do not seek to eliminate any
fluctuations in the underlying prices of the securities involved. Instead, the
transactions simply establish a rate of exchange that can be expected when a
fund settles its securities transactions in the future.

A fund also may engage in forward foreign currency exchange contracts to protect
the value of specific portfolio positions, which is called "position hedging."
When engaging in position hedging, a fund may enter into forward foreign
currency exchange transactions to protect against a decline in the values of the
foreign currencies in which portfolio securities are denominated (or against an
increase in the value of currency for securities that a fund expects to
purchase).

Buying and selling foreign currency exchange contracts involve costs and may
result in losses. The ability of a fund to engage in these transactions may be
limited by tax considerations. Although these techniques tend to minimize the
risk of loss due to decline in the value of the hedged currency, they tend to
limit any potential gain that might result from an increase in the value of such
currency. Transactions in these contracts involve certain other risks.
Unanticipated fluctuations in currency prices may result in a poorer overall
performance for a fund than if it had not engaged in any such transactions.
Moreover, there may be imperfect correlation between a fund's holdings of
securities denominated in a particular currency and forward contracts into

                                                                              14


which a fund enters. Such imperfect correlation may cause a fund to sustain
losses, which will prevent it from achieving a complete hedge or expose it to
risk of foreign exchange loss. Losses to a fund will affect its performance. The
Tax-Free Bond Funds do not invest in Forward Foreign Currency Exchange
Contracts.

FUTURES CONTRACTS are securities that represent an agreement between two parties
that obligates one party to buy and the other party to sell specific securities
at an agreed-upon price on a stipulated future date. In the case of futures
contracts relating to an index or otherwise not calling for physical delivery at
the close of the transaction, the parties usually agree to deliver the final
cash settlement price of the contract. Each fund may purchase and sell futures
contracts based on securities, securities indices and foreign currencies,
interest rates or any other futures contracts traded on U.S. exchanges or boards
of trade that the Commodities Future Trading Commission (the "CFTC") licenses
and regulates on foreign exchanges.

Each fund must maintain a small portion of its assets in cash to process
shareholder transactions in and out of it to pay its expenses. In order to
reduce the effect this otherwise uninvested cash would have on its performance a
fund may purchase futures contracts. Such transactions allow a fund's cash
balance to produce a return similar to that of the underlying security or index
on which the futures contract is based. Also, each fund may purchase or sell
futures contracts on a specified foreign currency to "fix" the price in U.S.
dollars of the foreign security it has acquired or sold or expects to acquire or
sell. Each fund may enter into futures contracts for these or other reasons.

When buying or selling futures contracts, each fund must place a deposit with
its broker equal to a fraction of the contract amount. This amount is known as
"initial margin" and must be in the form of liquid debt instruments, including
cash, cash-equivalents and U.S. government securities. Subsequent payments to
and from the broker, known as "variation margin" may be made daily, if
necessary, as the value of the futures contracts fluctuate. This process is
known as "marking-to-market." The margin amount will be returned to a fund upon
termination of the futures contracts assuming all contractual obligations are
satisfied. Each fund's aggregate initial and variation margin payments required
to establish its futures positions may not exceed 5% of its net assets. Because
margin requirements are normally only a fraction of the amount of the futures
contracts in a given transaction, futures trading can involve a great deal of
leverage. In order to avoid this, a fund will earmark or segregate assets for
any outstanding futures contracts as may be required by the federal securities
laws.

While each fund may purchase and sell futures contracts in order to simulate
full investment, there are risks associated with these transactions. Adverse
market movements could cause a fund to experience substantial losses when buying
and selling futures contracts. Of course, barring significant market
distortions, similar results would have been expected if a fund had instead
transacted in the underlying securities directly. There also is the risk of
losing any margin payments held by a broker in the event of its bankruptcy.
Additionally, a fund incurs transaction costs (i.e. brokerage fees) when
engaging in futures trading.

When interest rates are rising or securities prices are falling, a fund may
seek, through the sale of futures contracts, to offset a decline in the value of
its current portfolio securities. When rates are falling or prices are rising, a
fund, through the purchase of futures contracts, may attempt to secure better
rates or prices than might later be available in the market when they effect
anticipated purchases. Similarly, a fund may sell futures contracts on a
specified currency to protect against a decline in the value of that currency
and its portfolio securities that are denominated in that currency. Each fund
may purchase futures contracts on a foreign currency to

                                                                              15


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 market and credit risk than are more highly rated securities,
which primarily react to movements in the general level of interest rates. When
economic conditions appear to be deteriorating, medium- to lower-quality debt
securities may decline in value more than higher-quality debt securities due to
heightened concern over credit quality, regardless of prevailing interest rates.
Prices for high yield securities also could be affected by legislative and
regulatory developments. These laws could adversely affect a fund's net asset
value and investment practices, the secondary market value for high yield
securities, the financial condition of issuers of these securities and the value
of outstanding high yield securities.

INFLATION-INDEXED BONDS are fixed income securities whose value is periodically
adjusted according to the rate of inflation. Two structures are common. The U.S.
Treasury and some other issuers utilize a structure that accrues inflation into
the principal value of the bond. Most other issuers pay out the Consumer Price
Index ("CPI") accruals as part of a semiannual coupon.

Inflation-indexed securities issued by the U.S. Treasury have maturities of
approximately five, ten or thirty years, although it is possible that securities
with other maturities will be issued in the future. The U.S. Treasury securities
pay interest on a semi-annual basis equal to a fixed percentage of the
inflation-adjusted principal amount.

                                                                              16


If the periodic adjustment rate measuring inflation falls, the principal value
of inflation-indexed bonds will be adjusted downward, and consequently the
interest payable on these securities (calculated with respect to a smaller
principal amount) will be reduced. Repayment of the original bond principal upon
maturity (as adjusted for inflation) is guaranteed in the case of U.S. Treasury
inflation-indexed bonds, even during a period of deflation. However, the current
market value of the bonds is not guaranteed and will fluctuate. A fund may also
invest in other inflation-related bonds which may or may not provide a similar
guarantee. If a guarantee of principal is not provided, the adjusted principal
value of the bond repaid at maturity may be less than the original principal
amount.

The value of inflation-indexed bonds is expected to change in response to
changes in real interest rates. Real interest rates in turn are tied to the
relationship between nominal interest rates and the rate of inflation.
Therefore, if the rate of inflation rises at a faster rate than nominal interest
rates, real interest rates might decline, leading to an increase in value of
inflation-indexed bonds. In contrast, if nominal interest rates increase at a
faster rate than inflation, real interest rates might rise, leading to a
decrease in value of inflation-indexed bonds.

While these securities are expected to be protected from long-term inflationary
trends, short-term increases in inflation may lead to a decline in value. If
interest rates rise due to reasons other than inflation (for example, due to
changes in currency exchange rates), investors in these securities may not be
protected to the extent that the increase is not reflected in the bond's
inflation measure.

The periodic adjustment of U.S. inflation-indexed bonds is tied to the Consumer
Price Index for Urban Consumers ("CPI-U"), which is calculated monthly by the
U.S. Bureau of Labor Statistics. The CPI-U is a measurement of changes in the
cost of living, made up of components such as housing, food, transportation and
energy. Inflation-indexed bonds issued by a foreign government are generally
adjusted to reflect a comparable inflation index calculated by that government.
There can be no assurance that the CPI-U or any foreign inflation index will
accurately measure the real rate of inflation in the prices of goods and
services. Moreover, there can be no assurance that the rate of inflation in a
foreign country will be correlated to the rate of inflation in the United
States.

Any increase in the principal amount of an inflation-indexed bond will be
considered taxable ordinary income, even though investors do not receive their
principal until maturity.

ILLIQUID SECURITIES generally are any securities that cannot be disposed of
promptly and in the ordinary course of business at approximately the amount at
which a fund has valued the instruments. The liquidity of a fund's investments
is monitored under the supervision and direction of the Board of Trustees.
Investments currently not considered liquid include repurchase agreements not
maturing within seven days and certain restricted securities.

INDEX PARTICIPATIONS and index participation contracts provide the equivalent of
a position in the securities comprising an index, with each security's
representation equaling its index weighting. Moreover, their holders are
entitled to payments equal to the dividends paid by the underlying index
securities. Generally, the value of an index participation or index
participation contract will rise and fall along with the value of the related
index. A fund will invest in index participation contracts only if a liquid
market for them appears to exist. The Tax-Free Bond Funds do not engage in index
participations.

                                                                              17


INTERFUND BORROWING AND LENDING transactions may be entered into by all funds
and portfolios in the Schwab complex ("SchwabFunds(R)"). All loans are for
temporary or emergency purposes and the interest rates to be charged will be the
average of the overnight repurchase agreement rate and the short-term bank loan
rate. All loans are subject to numerous conditions designed to ensure fair and
equitable treatment of all participating funds/portfolios. The interfund lending
facility is subject to the oversight and periodic review of the Board of
Trustees of the SchwabFunds.

INTERNATIONAL BONDS are certain obligations or securities of foreign issuers,
including Eurodollar Bonds, which are U.S. dollar-denominated bonds issued by
foreign issuers payable in Eurodollars (U.S. dollars held in banks located
outside the United States, primarily Europe), Yankee Bonds, which are U.S.
dollar-denominated bonds issued in the U.S. by foreign banks and corporations,
and EuroBonds, which are bonds denominated in U.S. dollars and usually issued by
large underwriting groups composed of banks and issuing houses from many
countries. Investments in securities issued by foreign issuers, including
American Depositary Receipts and securities purchased on foreign securities
exchanges, may subject a fund to additional investment risks, such as adverse
political and economic developments, possible seizure, nationalization or
expropriation of foreign investments, less stringent disclosure requirements,
non-U.S. withholding taxes and the adoption of other foreign governmental
restrictions.

Additional risks include less publicly available information, the risk that
companies may not be subject to the accounting, auditing and financial reporting
standards and requirements of U.S. companies, the risk that foreign securities
markets may have less volume and therefore may be less liquid and their prices
more volatile than U.S. securities, and the risk that custodian and transaction
costs may be higher. Foreign issuers of securities or obligations are often
subject to accounting requirements and engage in business practices different
from those respecting domestic issuers of similar securities or obligations.
Foreign branches of U.S. banks and foreign banks may be subject to less
stringent reserve requirements than those applicable to domestic branches of
U.S. banks. The Tax-Free Bond Funds do not invest in international bonds.

LOAN INTERESTS, and other direct debt instruments or interests therein, may be
acquired by a fund. A loan interest is typically originated, negotiated, and
structured by a U.S. or foreign commercial bank, insurance company, finance
company, or other financial institution ("Agent") for a lending syndicate of
financial institutions. The Agent typically administers and enforces the loan on
behalf of the other lenders in the syndicate. In addition, an institution
typically but not always the Agent ("Collateral Bank"), holds collateral (if
any) on behalf of the lenders. When a Collateral Bank holds collateral, such
collateral typically consists of one or more of the following asset types:
inventory, accounts receivable, property, plant and equipment, intangibles,
common stock of subsidiaries or other investments. These loan interests may take
the form of participation interests in, assignments of or novations of a loan
during its second distribution, or direct interests during a primary
distribution. Such loan interests may be acquired from U.S. or foreign banks,
insurance companies, finance companies, or other financial institutions who have
made loans or are members of a lending syndicate or from other holders of loan
interests. A fund may also acquire loan interests under which a fund derives its
rights directly from the borrower. Such loan interests are separately
enforceable by a fund against the borrower and all payments of interest and
principal are typically made directly to a fund from the borrower. In the event
that a fund and other lenders become entitled to take possession of shared
collateral, it is anticipated that such collateral would be held in the custody
of the Collateral Bank for their mutual benefit. A fund may not act as an Agent,
a Collateral Bank, a guarantor or sole negotiator or structurer with respect to
a loan.

                                                                              18


The investment adviser will analyze and evaluate the financial condition of the
borrower in connection with the acquisition of any Loan Interest. Credit ratings
are typically assigned to Loan Interests in the same manner as with other fixed
income debt securities, and the investment adviser analyzes and evaluates these
ratings, if any, in deciding whether to purchase a Loan Interest. The investment
adviser also analyzes and evaluates the financial condition of the Agent and, in
the case of Loan Interests in which a fund does not have privity with the
borrower, those institutions from or through whom a fund derives its rights in a
loan ("Intermediate Participants").

In a typical loan, the Agent administers the terms of the loan agreement. In
such cases, the Agent is normally responsible for the collection of principal
and interest payments from the borrower and the apportionment of these payments
to the credit of all the institutions which are parties to the loan agreement. A
fund will generally rely upon the Agent or Intermediate Participant to receive
and forward to a fund its portion of the principal and interest payments on the
loan. Furthermore, unless under the terms of a participation agreement a fund
has direct recourse against the borrower, a fund will rely on the Agent and the
other members of the lending syndicate to use appropriate credit remedies
against the borrower. The Agent is typically responsible for monitoring
compliance with covenants contained in the loan agreement based upon reports
prepared by the borrower. The seller of the Loan Interest usually does, but is
often not obligated to, notify holders of Loan Interests of any failures of
compliance. The Agent may monitor the value of the collateral and, if the value
of the collateral declines, may accelerate the loan, may give the borrower an
opportunity to provide additional collateral or may seek other protection for
the benefit of the participants in the loan. The Agent is compensated by the
borrower for providing these services under a loan agreement, and such
compensation may include special fees paid upon structuring and funding the loan
and other fees paid on a continuing basis. With respect to Loan Interests for
which the Agent does not perform such administrative and enforcement functions,
a fund will perform such tasks on its own behalf, although a Collateral Bank
will typically hold any collateral on behalf of a fund and the other holders
pursuant to the applicable loan agreement.

A financial institution's appointment as Agent may usually be terminated in the
event that it fails to observe the requisite standard of care or becomes
insolvent, enters Federal Deposit Insurance Corporation ("FDIC") receivership,
or, if not FDIC insured, enters into bankruptcy proceedings. A successor agent
generally would be appointed to replace the terminated Agent, and assets held by
the Agent under the loan agreement should remain available to holders of Loan
Interests. However, if assets held by the Agent for the benefit of a fund were
determined to be subject to the claims of the Agent's general creditors, a fund
might incur certain costs and delays in realizing payment on a Loan Interest, or
suffer a loss of principal and/or interest. In situations involving Intermediate
Participants, similar risks may arise.

Purchasers of Loan Interests depend primarily upon the creditworthiness of the
borrower for payment of principal and interest. If a fund does not receive a
scheduled interest or principal payment on such indebtedness, a fund's share
price and yield could be adversely affected. Loans that are fully secured offer
a fund more protections than an unsecured loan in the event of non-payment of
scheduled interest or principal. However, there is no assurance that the
liquidation of collateral from a secured loan would satisfy the borrower's
obligation, or that the collateral can be liquidated. Indebtedness of borrowers
whose creditworthiness is poor involves substantially greater risks, and may be
highly speculative. Borrowers that are in bankruptcy or restructuring may never
pay off their indebtedness, or may pay only a small fraction of the amount owed.
Direct indebtedness of developing countries also will involve a risk that the
governmental entities responsible for the repayment of the debt may be unable,
or unwilling, to pay interest and repay principal when due.

                                                                              19


The Loan Interests market is in a developing phase with increased participation
among several investor types. The dealer community has become increasingly
involved in this secondary market. If, however, a particular Loan Interest is
deemed to be illiquid, it would be valued using procedures adopted by the Board
of Trustees. In such a situation, there is no guarantee that a fund will be able
to sell such Loan Interests, which could lead to a decline in the value of the
Loan Interests and the value of a fund's shares. The Tax-Free Bond Funds do not
invest in Loan Interests.

MATURITY OF INVESTMENTS will generally be determined using the portfolio
securities' final maturity dates. However for certain securities, maturity will
be determined using the security's effective maturity date. The effective
maturity date for a security subject to a put or demand feature is the demand
date, unless the security is a variable- or floating-rate security. If it is a
variable-rate security, its effective maturity date is the earlier of its demand
date or next interest rate change date. For variable-rate securities not subject
to a put or demand feature and floating-rate securities, the effective maturity
date is the next interest rate change date. The effective maturity of
mortgage-backed and certain other asset-backed securities is determined on an
"expected life" basis by the investment adviser. For the 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. The GNMA
Fund is not subject to maturity or duration restrictions.

MONEY MARKET SECURITIES are high-quality, short-term debt securities that may be
issued by entities such as the U.S. government, corporations and financial
institutions (like banks). Money market securities include commercial paper,
certificates of deposit, banker's acceptances, notes and time deposits.

Money market securities pay fixed, variable or floating rates of interest and
are generally subject to credit and interest rate risks. The maturity date or
price of and financial assets collateralizing a security may be structured in
order to make it qualify as or act like a money market security. These
securities may be subject to greater credit and interest rate risks than other
money market securities because of their structure. Money market securities may
be issued with puts or these can be sold separately.

MORTGAGE-BACKED SECURITIES ("MBS") and other ASSET-BACKED SECURITIES may be
purchased by a fund. MBS represent participations in mortgage loans, and include
pass-through securities, collateralized mortgage obligations and stripped
mortgage-backed securities. MBS may be issued or guaranteed by U.S. government
agencies or instrumentalities, such as the Government

                                                                              20


National Mortgage Association (GNMA or Ginnie Mae) and the Federal National
Mortgage Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage
Corporation (FHLMC or Freddie Mac).

The National Housing Act authorized GNMA to guarantee the timely payment of
principal and interest on securities backed by a pool of mortgages insured by
the Federal Housing Administration ("FHA") or guaranteed by the Veterans
Administration ("VA"). The GNMA guarantee is backed by the full faith and credit
of the U.S. Government. The GNMA is also empowered to borrow without limitation
from the U.S. Treasury if necessary to make any payments required under its
guarantee.

GNMA are mortgage securities which evidence an undivided interest in a pool or
pools of mortgages. GNMA Certificates that a fund may purchase are the "modified
pass-through" type, which entitle the holder to receive timely payment of all
interest and principal payments due on the mortgage pool, net of fees paid to
the "issuer" and GNMA, regardless of whether or not the mortgagor actually makes
the payment.

The average life of a GNMA Certificate is likely to be substantially shorter
than the original maturity of the mortgages underlying the securities.
Prepayments of principal by mortgagors and mortgage foreclosures will usually
result in the return of the greater part of principal investment long before the
maturity of the mortgages in the pool. Foreclosures impose no risk to principal
investment because of the GNMA guarantee, except to the extent that a Fund has
purchased the certificates above par in the secondary market.

FHLMC was created in 1970 to promote development of a nationwide secondary
market in conventional residential mortgages. The FHLMC issues two types of
mortgage pass-through securities ("FHLMC Certificates"): mortgage participation
certificates ("PCs") and guaranteed mortgage certificates ("GMCs"). PCs resemble
GNMA Certificates in that each PC represents a pro rata share of all interest
and principal payments made and owed on the underlying pool. The FHLMC
guarantees timely monthly payment of interest on PCs and the ultimate payment of
principal, but its issues are not backed by the full faith and credit of the
U.S. Government.

GMCs also represent a pro rata interest in a pool of mortgages. However, these
instruments pay interest semi-annually and return principal once a year in
guaranteed minimum payments. The expected average life of these securities is
approximately 10 years. The FHLMC guarantee is not backed by the full faith and
credit of the U.S. Government.

FNMA was established in 1938 to create a secondary market in mortgages the FHA
insures. FNMA issues guaranteed mortgage pass-through certificates ("FNMA
Certificates"). FNMA Certificates resemble GNMA Certificates in that each FNMA
Certificate represents a pro rata share of all interest and principal payments
made and owed on the underlying pool. FNMA guarantees timely payment of interest
and principal on FNMA Certificates. The FNMA guarantee is not backed by the full
faith and credit of the U.S. Government.

MBS may also be issued by private issuers, generally originators and investors
in mortgage loans, including savings associations, mortgage banks, commercial
banks, and special purpose entities (collectively, "private lenders"). MBS are
based on different types of mortgages including those on commercial real estate
and residential property. MBS issued by private lenders may be supported by
pools of mortgage loans or other MBS that are guaranteed, directly or
indirectly, by the U.S. government or one of its agencies or instrumentalities,
or they may be issued without any governmental guarantee of the underlying
mortgage assets but with some form of credit

                                                                              21


enhancement.

Asset-backed Securities ("ABS") have structural characteristics similar to MBS.
ABS represent direct or indirect participation in assets such as automobile
loans, credit card receivables, trade receivables, home equity loans (which
sometimes are categorized as MBS) or other financial assets. Therefore,
repayment depends largely on the cash flows generated by the assets backing the
securities. The credit quality of most ABS depends primarily on the credit
quality of the assets underlying such securities, how well the entity issuing
the security is insulated from the credit risk of the originator or any other
affiliated entities, and the amount and quality of any credit enhancement of the
securities. Payments or distributions of principal and interest on ABS may be
supported by credit enhancements including letters of credit, an insurance
guarantee, reserve funds and overcollateralization.

Commercial Mortgage-Backed Securities include securities that reflect an
interest in, and are secured by, mortgage loans on commercial real property. The
market for commercial mortgage-backed securities developed more recently and in
terms of total outstanding principal amount of issues is relatively small
compared to the market for residential single-family MBS. Many of the risks of
investing in commercial MBS reflect the risks of investing in the real estate
securing the underlying mortgage loans. These risks reflect the effects of local
and other economic conditions on real estate markets, the ability of tenants to
make loan payments, and the ability of a property to attract and retain tenants.
Commercial MBS may be less liquid and exhibit greater price volatility than
other types of mortgage- or asset-backed securities.

Collateralized Mortgage Obligations ("CMO") are a hybrid between mortgage-backed
bonds and mortgage pass-through securities. Similar to a bond, interest and
prepaid principal is paid, in most cases, on a monthly basis. CMOs may be
collateralized by whole mortgage loans, but are more typically collateralized by
portfolios of mortgage pass-through securities guaranteed by Ginnie Mae, Freddie
Mac, Fannie Mae, and their income streams.

CMOs are structured into multiple classes, each bearing a different stated
maturity. Actual maturity and average life will depend upon the prepayment
experience of the collateral. CMOs provide for a modified form of call
protection through a de facto breakdown of the underlying pool of mortgages
according to how quickly the loans are repaid. Monthly payment of principal
received from the pool of underlying mortgages, including prepayments, is first
returned to investors holding the shortest maturity class. Investors holding the
longer maturity classes receive principal only after the first class has been
retired. An investor is partially guarded against a sooner than desired return
of principal because of the sequential payments.

In a typical CMO transaction, a corporation ("issuer") issues multiple series
(e.g., A, B, C, Z) of CMO bonds ("Bonds"). Proceeds of the Bond offering are
used to purchase mortgages or mortgage pass-through certificates ("Collateral").
The Collateral is pledged to a third party trustee as security for the Bonds.
Principal and interest payments from the Collateral are used to pay principal on
the Bonds in the order A, B, C, Z. The Series A, B, and C Bonds all bear current
interest. Interest on the Series Z Bond is accrued and added to principal and a
like amount is paid as principal on the Series A, B, or C Bond currently being
paid off. When the Series A, B, and C Bonds are paid in full, interest and
principal on the Series Z Bond begins to be paid currently. With some CMOs, the
issuer serves as a conduit to allow loan originators (primarily builders or
savings and loan associations) to borrow against their loan portfolios.

The rate of principal payment on MBS and ABS generally depends on the rate of
principal payments received on the underlying assets which in turn may be
affected by a variety of

                                                                              22


economic and other factors. As a result, the price and yield on any MBS or ABS
is difficult to predict with precision and price and yield to maturity may be
more or less than the anticipated yield to maturity. If a fund purchases these
securities at a premium, a prepayment rate that is faster than expected will
reduce yield to maturity, while a prepayment rate that is slower than expected
will have the opposite effect of increasing the yield to maturity. Conversely,
if a fund purchases these securities at a discount, a prepayment rate that is
faster than expected will increase yield to maturity, while a prepayment rate
that is slower than expected will reduce yield to maturity. Amounts available
for reinvestment by a fund are likely to be greater during a period of declining
interest rates and, as a result, are likely to be reinvested at lower interest
rates than during a period of rising interest rates.

While many MBS and ABS are issued with only one class of security, many are
issued in more than one class, each with different payment terms. Multiple class
MBS and ABS are issued as a method of providing credit support, typically
through creation of one or more classes whose right to payments on the security
is made subordinate to the right to such payments of the remaining class or
classes. In addition, multiple classes may permit the issuance of securities
with payment terms, interest rates, or other characteristics differing both from
those of each other and from those of the underlying assets. Examples include
stripped securities, which are MBS and ABS entitling the holder to
disproportionate interest or principal compared with the assets backing the
security, and securities with classes having characteristics different from the
assets backing the securities, such as a security with floating interest rates
with assets backing the securities having fixed interest rates. The market value
of such securities and CMO's generally is more or less sensitive to changes in
prepayment and interest rates than is the case with traditional MBS and ABS, and
in some cases such market value may be extremely volatile.

CMO Residuals are mortgage securities issued by agencies or instrumentalities of
the U.S. Government or by private originators of, or investors in, mortgage
loans, including savings and loan associations, homebuilders, mortgage banks,
commercial banks, investment banks and special purpose entities of the
foregoing.

The cash flow generated by the mortgage assets underlying a series of CMOs is
applied first to make required payments of principal and interest on the CMOs
and second to pay the related administrative expenses of the issuer. The
residual in a CMO structure generally represents the interest in any excess cash
flow remaining after making the foregoing payments. Each payment of such excess
cash flow to a holder of the related CMO residual represents income and/or a
return of capital. The amount of residual cash flow resulting from a CMO will
depend on, among other things, the characteristics of the mortgage assets, the
coupon rate of each class of CMO, prevailing interest rates, the amount of
administrative expenses and the prepayment experience on the mortgage assets. In
particular, the yield to maturity on CMO residuals is extremely sensitive to
prepayments on the related underlying mortgage assets, in the same manner as an
interest-only ("IO") class of stripped mortgage-backed securities. See "Stripped
Mortgage-Backed Securities." In addition, if a series of a CMO includes a class
that bears interest at an adjustable rate, the yield to maturity on the related
CMO residual will also be extremely sensitive to changes in the level of the
index upon which interest rate adjustments are based. As described below with
respect to stripped mortgage-backed securities, in certain circumstances a fund
may fail to recoup fully its initial investment in a CMO residual.

CMO residuals are generally purchased and sold by institutional investors
through several investment banking firms acting as brokers or dealers. The CMO
residual market has only very recently developed and CMO residuals currently may
not have the liquidity of other more established securities trading in other
markets. Transactions in CMO residuals are generally

                                                                              23


completed only after careful review of the characteristics of the securities in
question. In addition, CMO residuals may, or pursuant to an exemption therefrom,
may not have been registered under the Securities Act of 1933, as amended (the
"1933 Act"). CMO residuals, whether or not registered under the 1933 Act, may be
subject to certain restrictions on transferability, and may be deemed "illiquid"
and subject to a Fund's limitations on investment in illiquid securities.

Stripped Mortgage-Backed Securities "SMBS" are derivative multi-class mortgage
securities. SMBS may be issued by agencies or instrumentalities of the U.S.
Government, or by private originators of, or investors in, mortgage loans,
including savings and loan associations, mortgage banks, commercial banks,
investment banks and special purpose entities of the foregoing.

SMBS are usually structured with two classes that receive different proportions
of the interest and principal distributions on a pool of mortgage assets. A
common type of SMBS will have one class receiving some of the interest and most
of the principal from the mortgage assets, while the other class will receive
most of the interest and the remainder of the principal. In the most extreme
case, one class will receive all of the interest (the "IO" class), while the
other class will receive all of the principal (the principal-only or "PO"
class). The yield to maturity on an IO class is extremely sensitive to the rate
of principal payments (including prepayments) on the related underlying mortgage
assets, and a rapid rate of principal payments may have a material adverse
effect on a fund's yield to maturity from these securities. If the underlying
mortgage assets experience greater than anticipated prepayments of principal, a
fund may fail to recoup some or all of its initial investment in these
securities even if the security is in one of the highest rating categories.

Under certain circumstances these securities may be deemed "illiquid" and
subject to a fund's limitations on investment in illiquid securities.

MUNICIPAL LEASES are obligations issued to finance the construction or
acquisition of equipment or facilities. These obligations may take the form of a
lease, an installment purchase contract, a conditional sales contract or a
participation interest in any of these obligations. Municipal leases may be
considered illiquid investments. Additionally, municipal leases are subject to
"nonappropriation risk," which is the risk that the municipality may terminate
the lease because funds have not been allocated to make the necessary lease
payments. The lessor would then be entitled to repossess the property, but the
value of the property may be less to private sector entities than it would be to
the municipality.

MUNICIPAL SECURITIES are debt securities issued by municipal issuers. Municipal
issuers include states, counties, municipalities, authorities and other
subdivisions, or the territories and possessions of the United States and the
District of Columbia, including their subdivisions, agencies and
instrumentalities and corporations. These securities may be issued to obtain
money for various public purposes, including the construction of a wide range of
public facilities such as airports, bridges, highways, housing, hospitals, mass
transportation, public utilities, schools, streets, and water and sewer works.
Other public purposes include refunding outstanding obligations, obtaining funds
for general operating expenses and obtaining funds to loan to other public
institutions and facilities.

Municipal securities also may be issued to finance various private activities,
including certain types of private activity bonds ("industrial development
bonds" under prior law). These securities may be issued by or on behalf of
public authorities to obtain funds to provide certain privately owned or
operated facilities. The Tax-Free Bond Funds may not be desirable investments
for

                                                                              24


"substantial users" of facilities financed by private activity bonds or
industrial development bonds or for "related persons" of substantial users
because distributions from these funds attributable to interest on such bonds
may not be tax exempt. The Tax-Free Bond Funds intend to limit investments in
these securities to 20% of their net assets. Shareholders should consult their
own tax advisors regarding the potential effect on them (if any) of any
investments in these funds.

Municipal securities may be owned directly or through participation interests,
and include general obligation or revenue securities, tax-exempt commercial
paper, notes and leases. Municipal securities generally are classified as
"general obligation" or "revenue" and may be purchased directly or through
participation interests. General obligation securities typically are secured by
the issuer's pledge of its full faith and credit and most often its taxing power
for the payment of principal and interest. Revenue securities typically are
payable only from the revenues derived from a particular facility or class of
facilities or, in some cases, from the proceeds of a special tax or other
specific revenue source. Private activity bonds and industrial development bonds
are, in most cases, revenue bonds and generally do not constitute the pledge of
the credit of the issuer of such bonds. The credit quality of private activity
bonds is frequently related to the credit standing of private corporations or
other entities.

In addition to bonds, municipalities issue short-term securities such as tax
anticipation notes, bond anticipation notes, revenue anticipation notes,
construction loan notes and tax-free commercial paper. Tax anticipation notes
typically are sold to finance working capital needs of municipalities in
anticipation of the receipt of property taxes on a future date. Bond
anticipation notes are sold on an interim basis in anticipation of a
municipality's issuance of a longer-term bond in the future. Revenue
anticipation notes are issued in expectation of the receipt of other types of
revenue, such as that available under the Federal Revenue Sharing Program.
Construction loan notes are instruments insured by the Federal Housing
Administration with permanent financing by Fannie Mae or Ginnie Mae at the end
of the project construction period. Tax-free commercial paper is an unsecured
promissory obligation issued or guaranteed by a municipal issuer. A fund may
purchase other municipal securities similar to the foregoing that are or may
become available, including securities issued to pre-refund other outstanding
obligations of municipal issuers.

A fund also may invest in moral obligation securities, which are normally issued
by special purpose public authorities. If the issuer of a moral obligation
security is unable to meet its obligation from current revenues, it may draw on
a reserve fund. The state or municipality that created the entity has only a
moral commitment, not a legal obligation, to restore the reserve fund.

The value of municipal securities may be affected by uncertainties with respect
to the rights of holders of municipal securities in the event of bankruptcy or
the taxation of municipal securities as a result of legislation or litigation.
For example, under federal law, certain issuers of municipal securities may be
authorized in certain circumstances to initiate bankruptcy proceedings without
prior notice to or the consent of creditors. Such action could result in
material adverse changes in the rights of holders of the securities. In
addition, litigation challenging the validity under the state constitutions of
present systems of financing public education has been initiated or adjudicated
in a number of states, and legislation has been introduced to effect changes in
public school finances in some states. In other instances, there has been
litigation challenging the issuance of pollution control revenue bonds or the
validity of their issuance under state or federal law, which ultimately could
affect the validity of those municipal securities or the tax-free nature of the
interest thereon.

Municipal securities pay fixed, variable or floating rates of interest, which
may be exempt from

                                                                              25


federal income tax and, typically, personal income tax of a state or locality.

The investment adviser relies on the opinion of the issuer's counsel, which is
rendered at the time the security is issued, to determine whether the security
is fit, with respect to its validity and tax status, to be purchased by a fund.

NON-PUBLICLY TRADED SECURITIES AND PRIVATE PLACEMENTS are securities that are
neither listed on a stock exchange nor traded over-the-counter, including
privately placed securities. Such unlisted securities may involve a higher
degree of business and financial risk that can result in substantial losses. As
a result of the absence of a public trading market for these securities, they
may be less liquid than publicly traded securities. Although these securities
may be resold in privately negotiated transactions, the prices realized from
these sales could be less than those originally paid by a fund or less than what
may be considered the fair value of such securities. Furthermore, companies
whose securities are not publicly traded may not be subject to the disclosure
and other investor protection requirements which might be applicable if their
securities were publicly traded. If such securities are required to be
registered under the securities laws of one or more jurisdictions before being
sold, a fund may be required to bear the expenses of registration.

OPTIONS CONTRACTS generally provide the right to buy or sell a security,
commodity, futures contract or foreign currency in exchange for an agreed upon
price. If the right is not exercised after a specified period, the option
expires and the option buyer forfeits the money paid to the option seller.

A call option gives the buyer the right to buy a specified number of shares of a
security at a fixed price on or before a specified date in the future. For this
right, the call option buyer pays the call option seller, commonly called the
call option writer, a fee called a premium. Call option buyers are usually
anticipating that the price of the underlying security will rise above the price
fixed with the call writer, thereby allowing them to profit. If the price of the
underlying security does not rise, the call option buyer's losses are limited to
the premium paid to the call option writer. For call option writers, a rise in
the price of the underlying security will be offset by the premium received from
the call option buyer. If the call option writer does not own the underlying
security, however, the losses that may ensue if the price rises could be
potentially unlimited. If the call option writer owns the underlying security or
commodity, this is called writing a covered call. All call option written by a
fund will be covered, which means that a fund will own the underlying security
or own a call option on the same underlying security with the same or lower
strike price.

A put option is the opposite of a call option. It gives the buyer the right to
sell a specified number of shares of a security at a fixed price on or before a
specified date in the future. Put option buyers are usually anticipating a
decline in the price of the underlying security, and wish to offset those losses
when selling the security at a later date. All put options a fund writes will be
covered, which means that a fund will deposit with its custodian cash, U.S.
government securities or other high-grade debt securities (i.e., securities
rated in one of the top three categories by Moody's Investor Service ("Moody's")
or Standard & Poor's ("S&P") or Fitch, Inc. or, if unrated, determined by the
investment adviser to be of comparable credit quality) with a value at least
equal to the exercise price of the put option, or will hold a put option on the
same underlying security with the same or higher strike price. The purpose of
writing such options is to generate additional income for a fund. However, in
return for the option premium, a fund accepts the risk that it may be required
to purchase the underlying securities at a price in excess of the securities'
market value at the time of purchase.

                                                                              26


A fund may purchase and write put and call options on any securities in which it
may invest or any securities index based on securities in which it may invest. A
fund may purchase and write such options on securities that are listed on
domestic or foreign securities exchanges or traded in the over-the-counter
market. Like futures contracts, option contracts are rarely exercised. Option
buyers usually sell the option before it expires. Option writers may terminate
their obligations under a written call or put option by purchasing an option
identical to the one it has written. Such purchases are referred to as "closing
purchase transactions." A fund may enter into closing sale transactions in order
to realize gains or minimize losses on options it has purchased or written.

An exchange-traded currency option position may be closed out only on an options
exchange that provides a secondary market for an option of the same series.
Although a fund generally will purchase or write only those options for which
there appears to be an active secondary market, there is no assurance that a
liquid secondary market will exist for any particular option or at any
particular time. If a fund is unable to effect a closing purchase transaction
with respect to options it has written, it will not be able to sell the
underlying securities or dispose of assets earmarked or held in a segregated
account until the options expire or are exercised. Similarly, if a fund is
unable to effect a closing sale transaction with respect to options it has
purchased, it would have to exercise the options in order to realize any profit
and will incur transaction costs upon the purchase or sale of underlying
securities.

Reasons for the absence of a liquid secondary market on an exchange include the
following: (1) there may be insufficient trading interest in certain options;
(2) an exchange may impose restrictions on opening transactions or closing
transactions or both; (3) trading halts, suspensions or other restrictions may
be imposed with respect to particular classes or series of options; (4) unusual
or unforeseen circumstances may interrupt normal operations on an exchange; (5)
the facilities of an exchange or the Options Clearing Corporation (the "OCC")
may not at all times be adequate to handle current trading volume; or (6) one or
more exchanges could, for economic or other reasons, decide or be compelled at
some future date to discontinue the trading of options (or a particular class or
series of options), although outstanding options on that exchange that had been
issued by the OCC as a result of trades on that exchange would continue to be
exercisable in accordance with their terms.

The ability to terminate over-the-counter options is more limited than with
exchange-traded options and may involve the risk that broker-dealers
participating in such transactions will not fulfill their obligations. Until
such time as the staff of the SEC changes its position, a fund will treat
purchased over-the-counter options and all assets used to cover written
over-the-counter options as illiquid securities, except that with respect to
options written with primary dealers in U.S. government securities pursuant to
an agreement requiring a closing purchase transaction at a formula price, the
amount of illiquid securities may be calculated with reference to a formula the
staff of the SEC approves.

Additional risks are involved with options trading because of the low margin
deposits required and the extremely high degree of leverage that may be involved
in options trading. There may be imperfect correlation between the change in
market value of the securities held by a fund and the prices of the options,
possible lack of liquid secondary markets, and the resulting inability to close
such positions prior to their maturity dates.

A fund may write or purchase an option only when the market value of that
option, when aggregated with the market value of all other options transactions
made on behalf of a fund, does not exceed 5% of its total assets.

                                                                              27


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 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

                                                                              28


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. The GNMA Fund will invest at least 80%
of its assets in securities issued by the GNMA.

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 are instruments under which a buyer acquires ownership of
certain securities (usually U.S. government securities) from a seller who agrees
to repurchase the securities at a mutually agreed-upon time and price, thereby
determining the yield during the buyer's holding period. Any repurchase
agreements a fund enters into will involve the fund as the buyer and banks or
broker-dealers as sellers. The period of repurchase agreements is usually short
- - from overnight to one week, although the securities collateralizing a
repurchase agreement may have longer maturity dates. Default by the seller might
cause a fund to experience a loss or delay in the liquidation of the collateral
securing the repurchase agreement. A fund also may incur disposition costs in
liquidating the collateral. In the event of a bankruptcy or other default of a
repurchase agreement's seller, a fund might incur expenses in enforcing its
rights, and could experience losses, including a decline in the value of the
underlying securities and loss of income. A fund will make payment under a
repurchase agreement only upon physical delivery or evidence of book entry
transfer of the collateral to the account of its custodian bank.

RESTRICTED SECURITIES are securities that are subject to legal restrictions on
their sale. Restricted securities may be considered to be liquid if an
institutional or other market exists for these securities. In making this
determination, a fund, under the direction and supervision of the Board of
Trustees, will take into account the following factors: (1) the frequency of
trades and quotes for the security; (2) the number of dealers willing to
purchase or sell the security and the number 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

                                                                              29


securities.

REVERSE REPURCHASE AGREEMENTS, MORTGAGE DOLLAR ROLLS AND SALE-BUYBACKS may be
used by a fund. A fund may engage in reverse repurchase agreements to facilitate
portfolio liquidity, a practice common in the mutual fund industry, or for
arbitrage transactions as discussed below. In a reverse repurchase agreement, a
fund would sell a security and enter into an agreement to repurchase the
security at a specified future date and price. A fund generally retains the
right to interest and principal payments on the security. Because a fund
receives cash upon entering into a reverse repurchase agreement, it may be
considered a borrowing. When required by guidelines of the SEC, a fund will set
aside permissible liquid assets earmarked or in a segregated account to secure
its obligations to repurchase the security.

A fund also may enter into mortgage dollar rolls, in which a fund would sell MBS
for delivery in the current month and simultaneously contract to purchase
substantially similar securities on a specified future date. While a fund would
forego principal and interest paid on the MBS during the roll period, a fund
would be compensated by the difference between the current sales price and the
lower price for the future purchase as well as by any interest earned on the
proceeds of the initial sale. A fund also could be compensated through the
receipt of fee income equivalent to a lower forward price. At the time a fund
would enter into a mortgage dollar roll, it would set aside permissible liquid
assets earmarked or in a segregated account to secure its obligation for the
forward commitment to buy MBS. Mortgage dollar roll transactions may be
considered a borrowing by a fund.

The mortgage dollar rolls and reverse repurchase agreements entered into by a
fund may be used as arbitrage transactions in which a fund will maintain an
offsetting position in short duration investment-grade debt obligations. Since a
fund will receive interest on the securities or repurchase agreements in which
it invests the transaction proceeds, such transactions may involve leverage.
However, since such securities or repurchase agreements will be high quality and
short duration, the investment adviser believes that such arbitrage transactions
present lower risks to a fund than those associated with other types of
leverage. There can be no assurance that a fund's use of the cash it receives
from a mortgage dollar roll will provide a positive return. The Tax-Free Bond
Funds do not invest in reverse repurchase agreements, mortgage dollar rolls or
sale-buy backs.

A fund also may effect simultaneous purchase and sale transactions that are
known as "sale-buybacks." A sale-buyback is similar to a reverse repurchase
agreement, except that in a sale-buyback, the counterparty who purchases the
security is entitled to receive any principal or interest payments made on the
underlying security pending settlement of the fund's repurchase of the
underlying security. A fund's obligations under a sale-buyback typically would
be offset by liquid assets equal in value to the amount of the fund's forward
commitment to repurchase the subject security.

SECURITIES LENDING of portfolio securities is a common practice in the
securities industry. A fund may engage in security lending arrangements with the
primary objective of increasing its income. For example, a fund may receive cash
collateral and it may invest it in short-term, interest-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.

                                                                              30


A fund may loan portfolio securities to qualified broker-dealers or other
institutional investors provided: (1) the loan is secured continuously by
collateral consisting of U.S. government securities, letters of credit, cash or
cash-equivalents or other appropriate instruments maintained on a daily
marked-to-market basis in an amount at least equal to the current market value
of the securities loaned; (2) a fund may at any time call the loan and obtain
the return of the securities loaned; (3) a fund will receive any interest or
dividends paid on the loaned securities; and (4) an aggregate market value of
securities loaned will not at any time exceed one-third of the total assets of a
fund, including collateral received from the loan (at market value computed at
the time of the loan).

Although voting rights with respect to loaned securities pass to the borrower,
the lender retains the right to recall a security (or terminate a loan) for the
purpose of exercising the security's voting rights. Efforts to recall such
securities promptly may be unsuccessful, especially for foreign securities or
thinly traded securities such as small-cap stocks. In addition, because
recalling a security may involve expenses to a fund, it is expected that a fund
will do so only where the items being voted upon are, in the judgment of the
investment adviser, either material to the economic value of the security or
threaten to materially impact the issuer's corporate governance policies or
structure.

SECURITIES OF OTHER INVESTMENT COMPANIES may be purchased and sold by a fund and
those issued by foreign investment companies. Mutual funds are registered
investment companies, which may issue and redeem their shares on a continuous
basis (open-end mutual funds) or may offer a fixed number of shares usually
listed on an exchange (closed-end mutual funds). Mutual funds generally offer
investors the advantages of diversification and professional investment
management, by combining shareholders' money and investing it in various types
of securities, such as stocks, bonds and money market securities. Mutual funds
also make various investments and use certain techniques in order to enhance
their performance. These may include entering into delayed-delivery and
when-issued securities transactions or swap agreements; buying and selling
futures contracts, illiquid and restricted securities and repurchase agreements
and borrowing or lending money and/or portfolio securities. The risks of
investing in mutual funds generally reflect the risks of the securities in which
the mutual funds invest and the investment techniques they may employ. Also,
mutual funds charge fees and incur operating expenses.

If a fund decides to purchase securities of other investment companies, a fund
intends to purchase shares of mutual funds in compliance with the requirements
of federal law or any applicable exemptive relief received from the SEC. Mutual
fund investments for a fund are currently restricted under federal regulations,
and therefore, the extent to which a fund may invest in another mutual fund may
be limited.

Funds in which a fund also may invest include unregistered or privately-placed
funds, such as hedge funds and off-shore funds, and unit investment trusts.
Hedge funds and off-shore funds are not registered with the SEC, and therefore
are largely exempt from the regulatory requirements that apply to registered
investment companies (mutual funds). As a result, these types of funds may have
greater ability to make investments or use investment techniques that offer a
higher degree of investment return, such as leveraging, which also may subject
their fund assets to 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

                                                                              31


as one month. This means investors would not be able to sell their shares of a
hedge fund until such time had past.

SHORT SALES may be used by a fund as part of its overall portfolio management
strategies or to offset a potential decline in a value of a security. For
example, a Bond Fund may use short sales may as a quantitative technique to
assemble a portfolio whose performance, average maturity and average duration is
expected to track that of its index. This technique may provide a more effective
hedge against interest rate risk than other types of hedging transactions, such
as selling futures contracts. A fund may sell a security short only if the fund
owns the security, or the right to obtain the security or equivalent securities,
or covers such short sale with liquid assets as required by the current rules
and interpretations of the SEC or its staff. When a fund makes a short sale, it
may borrow the security sold short and deliver it to the broker-dealer through
which it made the short sale as collateral for its obligation to deliver the
security upon conclusion of the sale. A fund also may have to pay a fee to
borrow particular securities and is often obligated to pay over any accrued
interest and dividends on such borrowed securities.

If the price of the security sold short increases between the time of the short
sale and the time a fund replaces the borrowed security, a fund will incur a
loss; conversely, if the price declines, a fund will realize a gain. Any gain
will be decreased, and any loss increased, by the transaction costs described
above. Selling securities short against the box involves selling a security that
a fund owns or has the right to acquire, for the delivery at a specified date in
the future. If a fund sells securities short against the box, it may protect
unrealized gains, but will lose the opportunity to profit on such securities if
the price rises. A short sale against the box is a taxable transaction to the
funds with respect to the securities sold short. The successful use of short
selling as a hedging strategy may be adversely affected by imperfect correlation
between movements in the price of the security sold short and the securities
being hedged. 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

                                                                              32


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 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 may be engaged by a fund during abnormal economic
or market conditions. Under normal conditions, the Tax-Free Bond Funds do not
generally intend to invest in securities that pay interest subject to federal
income tax; including federal alternative minimum tax. In addition, under normal
conditions, the Schwab California Short/Intermediate Tax-Free Bond Fund(TM) and
the Schwab California Long-Term Tax-Free Bond Fund(TM) do not intend to invest
in securities that pay interest subject to California personal income tax.
However, from time to time, as a defensive measure or under abnormal market
conditions, each of the Tax-Free Bond Funds may make temporary investments in
securities, the interest on which is subject to federal income 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. In addition, as a
defensive measure or under abnormal market conditions, the GNMA Fund may invest
up to 100% of its

                                                                              33


assets in cash, cash equivalents or other high quality short-term investments.

U.S. GOVERNMENT SECURITIES are issued by the U.S. Treasury or issued or
guaranteed by the U.S. government or any of its agencies or instrumentalities.
Not all U.S. government securities are backed by the full faith and credit of
the United States. Some U.S. government securities, such as those issued by
Fannie Mae, Freddie Mac, the Student Loan Marketing Association (SLMA or Sallie
Mae), and the Federal Home Loan Banks (FHLB), are supported by a line of credit
the issuing entity has with the U.S. Treasury. Others are supported solely by
the credit of the issuing agency or instrumentality such as obligations issued
by the Federal Farm Credit Banks Funding Corporation (FFCB). There can be no
assurance that the U.S. government will provide financial support to U.S.
government securities of its agencies and instrumentalities if it is not
obligated to do so under law. Of course U.S. government securities, including
U.S. Treasury securities, are among the safest securities, however, not unlike
other debt securities, they are still sensitive to interest rate changes, which
will cause their prices to fluctuate.

VARIABLE- AND FLOATING-RATE DEBT SECURITIES pay an interest rate, which is
adjusted either periodically or at specific intervals or which floats
continuously according to a formula or benchmark. Although these structures
generally are intended to minimize the fluctuations in value that occur when
interest rates rise and fall, some structures may be linked to a benchmark in
such a way as to cause greater volatility to the security's value.

Some variable-rate securities may be combined with a put or demand feature
(variable-rate demand securities) that entitles the holder to the right to
demand repayment in full or to resell at a specific price and/or time. While the
demand feature is intended to reduce credit risks, it is not always
unconditional, and may make the securities more difficult to sell quickly
without losses. There are risks involved with these securities because there may
be no active secondary market for a particular variable-rate demand security
purchased by a fund. In addition, a fund may exercise its demand rights only at
certain times. A fund could also suffer losses in the event that the issuer
defaults on its obligation.

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

                                                                              34


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.

                             INVESTMENT LIMITATIONS

The following investment limitations are fundamental investment polices and
restrictions and may be changed only by vote of a majority of a fund's
outstanding voting shares.

SCHWAB SHORT-TERM BOND MARKET FUND(TM) AND SCHWAB TOTAL BOND MARKET FUND(TM)
MAY:

1)       Lend or borrow money to the extent permitted by the Investment Company
         Act of 1940 or rules or regulations thereunder, as such statute, rules
         or regulations may be amended from time to time.

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.

                                                                              35


5)       Not purchase securities of an issuer, except as consistent with the
         maintenance of its status as an open-end diversified company under the
         1940 Act, the rules or regulations thereunder or any exemption
         therefrom, as such statute, rules or regulations may be amended or
         interpreted from time to time.

6)       Not purchase securities of other investment companies, except as
         permitted by the Investment Company Act of 1940.

7)       Issue senior securities to the extent permitted by the Investment
         Company Act of 1940 or the rules or regulations thereunder, as such
         statute, rules or regulations may be amended from time to time.

8)       Purchase or sell commodities, commodities contracts, futures contracts,
         or real estate to the extent permitted by the Investment Company Act of
         1940 or rules or regulations thereunder, as such statute, rules or
         regulations may be amended from time to time.

SCHWAB SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM), SCHWAB LONG-TERM BOND
FUND(TM), SCHWAB CALIFORNIA SHORT/INTERMEDIATE TAX-FREE BOND FUND(TM) AND SCHWAB
CALIFORNIA LONG-TERM TAX-FREE BOND FUND(TM) MAY NOT:

1)       Concentrate investments in a particular industry or group of
         industries, as concentration is defined under the 1940 Act, the rules
         or regulations thereunder or any exemption therefrom, as such statute,
         rules or regulations may be amended or interpreted from time to time.

2)       Purchase or sell commodities or real estate, except to the extent
         permitted under the 1940 Act, the rules or regulations thereunder or
         any exemption therefrom, as such statute, rules or regulations may be
         amended or interpreted from time to time.

3)       Purchase securities of other investment companies, except as permitted
         by the 1940 Act.

4)       Make loans to other persons, except to the extent permitted under the
         1940 Act, the rules or regulations thereunder or any exemption
         therefrom, as such statute, rules or regulations may be amended or
         interpreted from time to time.

5)       Borrow money, except to the extent permitted under the 1940 Act, the
         rules or regulations thereunder or any exemption therefrom, as such
         statute, rules or regulations may be 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.

                                                                              36


THE YIELDPLUS FUND AND GNMA 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, 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.

                                                                              37


Senior Securities. Senior securities may include any obligation or instrument
issued by a fund evidencing indebtedness. The 1940 Act generally prohibits funds
from issuing senior securities, although it provides allowances for certain
borrowings and certain other investments, such as short sales, reverse
repurchase agreements, firm commitment agreements and standby commitments, with
appropriate earmarking or segregation of assets to cover such obligation.

The following are non-fundamental investment policies and restrictions and may
be changed by the Board of Trustees.

THE BOND FUNDS MAY NOT:

1)       Sell securities short unless it owns the security or the right to
         obtain the security or equivalent securities, or unless it covers such
         short sale as required by current SEC rules and interpretations
         (transactions in futures contracts, options and other derivative
         instruments are not considered selling securities short).

2)       Purchase securities on margin, except such short-term credits as may be
         necessary for the clearance of purchases and sales of securities and
         provided that margin deposits in connection with futures contracts,
         options on futures or other derivative instruments shall not constitute
         purchasing securities on margin.

3)       Lend any security or make any other loan if, as a result, more than 33
         1/3% of its total assets would be lent to other parties (this
         restriction does not apply to purchases of debt securities or
         repurchase agreements).

4)       Borrow money except that each fund may (i) borrow money from banks or
         through an interfund lending facility, if any, only for temporary or
         emergency purposes (and not for leveraging) and (ii) engage in reverse
         repurchase agreements with any party; provided that (i) and (ii) in
         combination do not exceed 33 1/3% of its total assets (any borrowings
         that come to exceed this amount will be reduced to the extent necessary
         to comply with the limitation within three business days).

5)       Purchase securities (other than securities issued or guaranteed by the
         U.S. government, its agencies or instrumentalities) if, as a result of
         such purchase, 25% or more of the value of its total assets would be
         invested in any industry or group of industries (except that each fund
         may purchase securities to the extent that its index is also so
         concentrated).

6)       Invest more than 15% of its net assets in illiquid securities.

7)       Purchase or sell commodities, commodity contracts or real estate,
         including interests in real estate limited partnerships, provided that
         the fund may (i) purchase securities of companies that deal in real
         estate or interests therein (including REITs), (ii) purchase or sell
         futures contracts, options contracts, equity index participations and
         index participation contracts, and (iii) purchase securities of
         companies that deal in precious metals or interests therein.

THE TAX-FREE BOND FUNDS MAY NOT:

1)       Sell securities short unless it owns the security or the right to
         obtain the security or equivalent securities, or unless it covers such
         short sale as required by current SEC rules

                                                                              38


         and interpretations (transactions in futures contracts, options and
         other derivative instruments are not considered selling securities
         short).

2)       Purchase securities on margin, except such short-term credits as may be
         necessary for the clearance of purchases and sales of securities and
         provided that margin deposits in connection with futures contracts,
         options on futures or other derivative instruments shall not constitute
         purchasing securities on margin.

3)       Purchase securities the income of which is subject to federal
         alternative minimum tax if, by reason of such purchase, the total
         income earned by such securities would exceed 20% of all income earned
         by a fund.

4)       Under normal circumstances, invest less than 65% of its total assets in
         securities deemed by the investment adviser to be bonds.

5)       Borrow money except that each fund may (i) borrow money from banks or
         through an interfund lending facility, if any, only for temporary or
         emergency purposes (and not for leveraging) and (ii) engage in reverse
         repurchase agreements with any party; provided that (i) and (ii) in
         combination do not exceed 33 1/3% of its total assets (any borrowings
         that come to exceed this amount will be reduced to the extent necessary
         to comply with the limitation within three business days).

6)       Lend any security or make any other loan if, as a result, more than 33
         1/3% of its total assets would be lent to other parties (this
         restriction does not apply to purchases of debt securities or
         repurchase agreements).

7)       Invest more than 15% of its net assets in illiquid securities.

8)       Purchase securities (other than securities issued or guaranteed by the
         U.S. government, its agencies or instrumentalities) if, as a result of
         such purchase, 25% or more of the value of its total assets would be
         invested in any industry, or group of industries (although securities
         issued by governments or political subdivisions of governments are not
         considered to be securities subject to this industry concentration
         restriction).

9)       Purchase or sell commodities, commodity contracts or real estate,
         including interests in real estate limited partnerships, provided that
         the fund may (i) purchase securities of companies that deal in real
         estate or interests therein (including REITs), (ii) purchase or sell
         futures contracts, options contracts, equity index participations and
         index participation contracts, and (iii) purchase securities of
         companies that deal in precious metals or interests therein.

THE YIELDPLUS FUND AND THE GNMA 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

                                                                              39


         and interpretations (transactions in futures contracts, options and
         other derivative instruments are not considered selling securities
         short).

4)       Purchase securities on margin, except such short-term credits as may be
         necessary for the clearance of purchases and sales of securities and
         provided that margin deposits in connection with futures contracts,
         options on futures or other derivative instruments shall not constitute
         purchasing securities on margin.

5)       Borrow money except that the fund may (i) borrow money from banks or
         through an interfund lending facility, if any, only for temporary or
         emergency purposes (and not for leveraging) and (ii) engage in reverse
         repurchase agreements with any party; provided that (i) and (ii) in
         combination do not exceed 33 1/3% of its total assets (any borrowings
         that come to exceed this amount will be reduced to the extent necessary
         to comply with the limitation within three business days).

6)       Purchase securities (other than securities issued or guaranteed by the
         U.S. government, its agencies or instrumentalities) if, as a result of
         such purchase, 25% or more of the value of its total assets would be
         invested in any industry or group of industries.

7)       Lend any security or make any other loan if, as a result, more than 33
         1/3% of its total assets would be lent to other parties (this
         restriction does not apply to purchases of debt securities or
         repurchase agreements).

8)       Purchase or sell commodities, commodity contracts or real estate,
         including interests in real estate limited partnerships, provided that
         the fund may (i) purchase securities of companies that deal in real
         estate or interests therein (including REITs), (ii) purchase or sell
         futures contracts, options contracts, equity index participations and
         index participation contracts, and (iii) purchase securities of
         companies that deal in precious metals or interests therein.

SUBSEQUENT CHANGES IN NET ASSETS

Policies and investment limitations that state a maximum percentage of assets
that may be invested in a security or other asset, or that set forth a quality
standard shall be measured immediately after and as a result of the fund's
acquisition of such security or asset, unless otherwise noted. Except with
respect to limitations on borrowing and futures and option contracts, any
subsequent change in net assets or other circumstances does not require a fund
to sell an investment if it could not then make the same investment. With
respect to the limitation on illiquid securities, in the event that a subsequent
change in net assets or other circumstances cause a fund to exceed its
limitation, the fund will take steps to bring the aggregate amount of illiquid
instruments back within the limitations as soon as reasonably practicable.

                             MANAGEMENT OF THE FUNDS

Each fund is overseen by a Board of Trustees. The trustees are responsible for
protecting shareholder interests. The trustees regularly meet to review the
investment activities, contractual arrangements and the investment performance
of each fund. The trustees met 7 times during the most recent fiscal year.

Certain trustees are "interested persons." A trustee may be considered an
interested person of the trust under the 1940 Act if he or she is an officer,
director or employee of Charles Schwab

                                                                              40


Investment Management, Inc. ("CSIM") or Charles Schwab & Co., Inc. ("Schwab"). A
trustee also may be considered an interested person of the trust under the 1940
Act if he or she owns stock of The Charles Schwab Corporation, a publicly traded
company and the parent company of the funds' investment adviser and distributor.

The information below is provided as of August 31, 2003. Each of the
below-referenced officers and/or trustees also serves in the same capacity as
described for the trust, for Schwab Capital Trust, The Charles Schwab Family of
Funds and Schwab Annuity Portfolios (the "fund complex") which as of August 31,
2003 included 49 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,
other directorships and affiliations, if any, with The Charles Schwab
Corporation, Schwab and CSIM are as follows:



                                  TERM OF
                                  OFFICE
                                    AND                PRINCIPAL
                                  LENGTH              OCCUPATIONS
  NAME AND       POSITION(S)        OF                DURING THE
  DATE OF         WITH THE         TIME                PAST FIVE                    OTHER
   BIRTH           TRUST         SERVED(1)               YEARS                  DIRECTORSHIPS

                                  INDEPENDENT TRUSTEES
                                                                    

DONALD F.        Trustee        Trustee of         Chief Executive
DORWARD                         Schwab             Officer, Dorward
September 23,                   Investments        & Associates
1931                            since 1991.        (corporate
                                                   management,
                                                   marketing and
                                                   communications
                                                   consulting firm).
                                                   From 1996 to
                                                   1999, Executive
                                                   Vice President
                                                   and Managing
                                                   Director, Grey
                                                   Advertising.

ROBERT G.        Trustee        Trustee of         Chairman, Chief
HOLMES                          Schwab             Executive
May 15, 1931                    Investments        Officer and
                                since 1991.        Director, Semloh
                                                   Financial, Inc.
                                                   (international
                                                   financial services
                                                   and investment


- ---------------
(1) Trustees remain in office until they resign, retire or are removed by
shareholder vote. The SchwabFunds retirement policy requires that independent
trustees elected after January 1, 2000 retire at age 72 or after twenty years of
service as a trustee, whichever comes first. Independent trustees elected prior
to January 1, 2000 will retire on the following schedule: Messrs. Holmes and
Dorward will retire on December 31, 2007, and Messrs. Stephens and Wilsey will
retire on December 31, 2010.

                                                                              41


                                                                    
                                                   advisory firm).

DONALD R.        Trustee        Trustee of         Managing
STEPHENS                        Schwab             Partner, D.R.
June 28, 1938                   Investments        Stephens &
                                since 1991.        Company
                                                   (investments).
                                                   Prior to 1996,
                                                   Chairman and
                                                   Chief Executive
                                                   Officer of North
                                                   American Trust
                                                   (real estate
                                                   investment trust).

MICHAEL W.       Trustee        Trustee of         Chairman and
WILSEY                          Schwab             Chief Executive
August 18, 1943                 Investments        Officer, Wilsey
                                since 1991.        Bennett, Inc.
                                                   (truck and air
                                                   transportation,
                                                   real estate
                                                   investment and
                                                   management, and
                                                   investments).

MARIANN          Trustee        Trustee of         Chairman of                  Ms. Byerwalter also
BYERWALTER                      Schwab             JDN Corporate                is on the Board of
August 13, 1960                 Investments        Advisory LLC.                Stanford University,
                                since 2000.        From 1996 to                 America First
                                                   2001, Ms.                    Companies, Omaha,
                                                   Byerwalter was               NE (venture
                                                   the Vice                     capital/fund
                                                   President for                management),
                                                   Business Affairs             Redwood Trust, Inc.
                                                   and Chief                    (mortgage finance),
                                                   Financial Officer            Stanford Hospitals
                                                   of Stanford                  and Clinics, SRI
                                                   University and, in           International
                                                   2001, Special                (research), PMI
                                                   Advisor to the               Group, Inc.
                                                   President of                 (mortgage
                                                   Stanford                     insurance) and
                                                   University.(2)               Lucile Packard
                                                                                Children's Hospital;
                                                                                Director until 2002,




- ---------------
(2) Charles R. Schwab, an interested trustee (see below) has served as a Trustee
of Stanford University since December 1993. From 1996 to 2001, Ms. Byerwalter
was Chief Financial Officer of Stanford.

                                                                              42


                                                                           
                                                                                       LookSmart, Ltd. (an
                                                                                       Internet infrastructure
                                                                                       company).

WILLIAM A. HASLER       Trustee        Trustee of        Co-Chief Executive            Mr. Hasler also is on the Board
November 22, 1941                      Schwab            Officer, Aphton               of Solectron Corporation
                                       Investments       Corporation                   (manufacturing), Tenera, Inc.
                                       since 2000.       (bio-pharmaceuticals).        (services and software),
                                                         Prior to August 1998, Mr.     Airlease Ltd. (aircraft
                                                         Hasler was Dean of the        leasing), Mission West
                                                         Haas School of Business at    Properties (commercial real
                                                         the University of             estate) and Digital Microwave
                                                         California, Berkeley          Corporation (a network
                                                         (higher education).           equipment corporation).

GERALD B. SMITH         Trustee        Trustee of        Since 1990, Chairman and      Mr. Smith is also on the Board
September 28, 1950                     Schwab            Chief Executive Officer       of Rorento N.V. (investments -
                                       Investments       and founder of Smith          Netherlands) and Cooper
                                       since 2000.       Graham & Co. (investment      Industries (electrical
                                                         advisors).                    products, tools and hardware),
                                                                                       and is a member of the audit
                                                                                       committee of Northern Border
                                                                                       Partners, L.P. (energy);
                                                                                       Director until 2002, Pennzoil
                                                                                       Quaker State Company (oil and
                                                                                       gas).



                                                                              43



                               INTERESTED TRUSTEES
                                                                           
CHARLES R.              Chairman       Chairman and      Chairman and Director, The    Director, U.S. Trust
SCHWAB 3               and Trustee     Trustee of        Charles Schwab                Corporation, United States
July 29, 1937                          Schwab            Corporation; Chief            Trust Company of New York, The
                                       Investments       Executive Officer and         Gap, Inc. (a clothing
                                       since 1991.       Director, Schwab Holdings,    retailer), Siebel Systems (a
                                                         Inc.; Chairman and            software company) and Xign,
                                                         Director, Charles Schwab &    Inc. (a developer of
                                                         Co., Inc., Charles Schwab     electronic payment systems);
                                                         Investment Management,        Trustee, Stanford University,
                                                         Inc.; Chairman, Charles       since 1993; Director until
                                                         Schwab Holdings (UK);         January 1999, Schwab
                                                         Chairman and Chief            Retirement Plan Services,
                                                         Executive Officer, Schwab     Inc., Mayer & Schweitzer, Inc.
                                                         (SIS) Holdings, Inc. I,       (a securities brokerage
                                                         Schwab International          subsidiary of The Charles
                                                         Holdings, Inc.                Schwab Corporation),
                                                                                       Performance Technologies, Inc.
                                                                                       (technology company),
                                                                                       TrustMark, Inc.; Director
                                                                                       until July 2001, The Charles
                                                                                       Schwab Trust Company; Director
                                                                                       until March 2002, Audiobase,
                                                                                       Inc. (full-service audio
                                                                                       solutions for the Internet);
                                                                                       Director until May 2002,
                                                                                       Vodaphone AirTouch PLC (a
                                                                                       telecommunications company).

DAWN LEPORE              Trustee        Trustee of          Vice Chairman -            Director of Wal-Mart Stores,
March 21, 1954                           Schwab               Technology,              Operations, Inc.


- ----------------------------------
3 In addition to their employment with the investment adviser and the
distributor, Messrs. Schwab and Lyons, and certain of Mr. Lyons's immediate and
eBay Inc. family members, also own stock of The Charles Schwab Corporation.

                                                                              44



                                                                           
                                          Investments    Operation and                 and eBay Inc.
                                          since 2003.    Administration of the
                                                         Company and Schwab since
                                                         July 2002 and Vice Chairman
                                                         - Technology and
                                                         Administration of the
                                                         Company and Schwab from
                                                         October 2001 to July 2002.
                                                         Ms. Lepore was Vice
                                                         Chairman and Chief
                                                         Information Officer of the
                                                         Company and Schwab from
                                                         1999 to October 2001 and
                                                         Executive Vice President
                                                         and Chief Information
                                                         Officer of the Company and
                                                         Schwab from 1993 to 1999.
                                                         Ms. Lepore joined Schwab in
                                                         1983.

JEFFREY M. LYONS (3)     Trustee           Trustee of    Executive Vice President,
February 22, 1955                          Schwab        Asset Management Products &
                                           Investments   Services since September
                                           since 2002.   2001, Charles Schwab & Co.,
                                                         Inc. Prior to September
                                                         2001, Mr. Lyons was
                                                         Executive Vice President,
                                                         Mutual Funds,



- ----------------------------------
(3) In addition to their employment with the investment adviser and the
distributor, Messrs. Schwab and Lyons, and certain of Mr. Lyons's immediate
family members, also own stock of The Charles Schwab Corporation.

                                                                              45



                                                
                                                         Charles Schwab & Co., Inc
                                    OFFICERS

RANDALL W. MERK        President       Officer of        President and Chief
July 25, 1954          and Chief       Schwab            Executive Officer, Charles
                       Executive       Investments       Schwab Investment
                       Officer         since 2002.       Management, Inc. and
                                                         Executive Vice President,
                                                         Charles Schwab & Co., Inc.
                                                         Director, Charles Schwab
                                                         Asset Management (Ireland)
                                                         Limited; Director, Charles
                                                         Schwab Worldwide Funds PLC.
                                                         Prior to September 2002,
                                                         Mr. Merk was President and
                                                         Chief Investment Officer,
                                                         American Century Investment
                                                         Management, and Director,
                                                         American Century Companies,
                                                         Inc. (June 2001 to August
                                                         2002); Chief Investment
                                                         Officer, Fixed Income,
                                                         American Century Companies,
                                                         Inc. (January 1997 to June
                                                         2001).



                                                                              46



                                                                           
TAI-CHIN TUNG          Treasurer       Officer of        Senior Vice President and     Director, Charles Schwab
March 7, 1951          and Principal   Schwab            Chief Financial Officer,      Asset Management (Ireland)
                       Financial       Investments       Charles Schwab Investment     Limited and Charles Schwab
                       Officer.        since 1996.       Management, Inc.; Vice        Worldwide Funds PLC.
                                                         President, The Charles
                                                         Schwab Trust Company.

STEPHEN B. WARD        Senior Vice     Officer of        Director, Senior Vice
April 5, 1955          President       Schwab            President and Chief
                       and Chief       Investments       Investment Officer, Charles
                       Investment      since 1991.       Schwab Investment
                       Officer.                          Management, Inc.; Chief
                                                         Investment Officer, The
                                                         Charles Schwab Trust
                                                         Company.

KOJI E. FELTON          Secretary      Officer of        Senior Vice President,
March 13, 1961                         Schwab            Chief Counsel and Assistant
                                       Investments       Corporate Secretary,
                                       since 1998.       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.



                                                                              47



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 2, 2003 meeting, the Board of Trustees, the trustees, including a
majority of independent trustees, approved the fund's 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 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.

In its deliberation, the board did not identify any particular information that
was all-important or

                                                                              48



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, 2003.

                               TAXABLE BOND FUNDS



                                    ($)
                         Aggregate Compensation                                   ($)
                            from each Fund(1)                                    Total
                                                    Pension or Retirement     Compensation
                         Short-Term   Total Bond     Benefits Accrued as       from Fund
Name of Trustee            Bond         Market      Part of Fund Expenses       Complex(2)
- --------------------    -----------   ----------    ---------------------     ------------
                                                                  
Charles R. Schwab              0             0             N/A                          0

John Philip Coghlan(3)         0             0             N/A                          0

Dawn Lepore(4)                 0             0             N/A                          0

Jeffrey M. Lyons               0             0             N/A                          0

Mariann Byerwalter        $1,655        $2,133             N/A                   $153,025

Donald F. Dorward         $1,655        $2,133             N/A                   $153,025

William A. Hasler
                          $1,655        $2,133             N/A                   $153,025
Robert G. Holmes

Gerald B. Smith           $1,655        $2,133             N/A                   $153,025


- --------------------------------------
(1) Compensation for the fiscal period ending August 31, 2003.

(2) Unless otherwise stated, information is for the fund complex which included
    49 funds as of August 31, 2003.

(3) Mr. Coghlan resigned from the board effective August 26, 2003.

(4) Ms. Lepore was appointed to the board on August 26, 2003.

                                                                              49






                                   ($)
                        Aggregate Compensation                                    ($)
                           from each Fund(1)                                     Total
                         Short-Term   Total Bond    Pension or Retirement     Compensation
                                                     Benefits Accrued as       from Fund
Name of Trustee            Bond         Market      Part of Fund Expenses       Complex(2)
- --------------------    -----------   ----------    ---------------------     ------------
                                                                  
Donald R. Stephens        $1,655        $2,133             N/A                   $153,025

Michael W. Wilsey         $1,589        $2,046             N/A                   $147,300



                               TAX-FREE BOND FUNDS



                                                   ($)
                                 Aggregate Compensation from each Fund(1)
                                                                                  Pension or
                                                                                  Retirement
                                                    California                    Benefits          ($)
                        Short/Inter-                Short/Inter-    California    Accrued as       Total
                          mediate     Long-Term       mediate        Long Term     Part of      Compensation
   Name of               Tax-Free      Tax-Free      Tax-Free        Tax-Free        Fund        from Fund
   Trustee               Bond Fund    Bond Fund      Bond Fund       Bond Fund     Expenses      Complex(2)
- ----------------------  -----------   ----------    ------------    ----------    ----------    ------------
                                                                                 
Charles R. Schwab             0              0             0              0          N/A                 0

John Philip Coghlan(3)        0              0             0              0          N/A                 0

Dawn Lepore(4)                0              0             0              0          N/A                 0

Jeffrey M. Lyons              0              0             0              0          N/A                 0

Mariann Byerwalter       $1,241         $1,175        $1,272         $1,318          N/A          $153,025

Donald F. Dorward        $1,241         $1,175        $1,272         $1,318          N/A          $153,025

William A. Hasler        $1,241         $1,175        $1,272         $1,318          N/A          $153,025

Robert G. Holmes         $1,241         $1,175        $1,272         $1,318          N/A          $153,025

Gerald B. Smith          $1,241         $1,175        $1,272         $1,318          N/A          $153,025


- -----------------------------------
(1) Compensation for the fiscal period ending August 31, 2003.

(2) Unless otherwise stated, information is for the fund complex which included
    49 funds as of August 31, 2003.

(3) Mr. Coghlan resigned from the board effective August 26, 2003.

(4) Ms. Lepore was appointed to the board on August 26, 2003.

                                                                              50





                                                ($)
                             Aggregate Compensation from each Fund(1)
                                                                                  Pension or
                                                                                  Retirement
                                                    California                    Benefits          ($)
                        Short/Inter-                Short/Inter-    California    Accrued as       Total
                          mediate     Long-Term       mediate        Long Term     Part of      Compensation
   Name of               Tax-Free      Tax-Free      Tax-Free        Tax-Free        Fund        from Fund
   Trustee               Bond Fund    Bond Fund      Bond Fund       Bond Fund     Expenses       Complex(2)
- --------------------    -----------   ----------    ------------    ----------    ----------    ------------
                                                                                 
Donald R. Stephens       $1,241         $1,175        $1,272         $1,318          N/A          $153,025

Michael W. Wilsey        $1,191         $1,128        $1,220         $1,264          N/A          $147,300


                                 YIELDPLUS FUND



                                                                      Pension or
                                                                      Retirement
                                                                       Benefits        ($)
                                                        ($)           Accrued as      Total
                                                     Aggregate         Part of      Compensation
                                                    Compensation        Fund        from Fund
Name of Trustee                                    from the Fund(1)     Expenses      Complex(2)
- -------------------                                ----------------   ----------    -----------
                                                                           
Charles R. Schwab                                         0              N/A             0

John Philip Coghlan(3)                                    0              N/A             0

Dawn Lepore(4)                                            0              N/A             0

Jeffrey M. Lyons                                          0              N/A             0

Mariann Byerwalter                                      $2,903           N/A         $153,025

Donald F. Dorward                                       $2,903           N/A         $153,025

William A. Hasler                                       $2,903           N/A         $153,025

Robert G. Holmes                                        $2,903           N/A         $153,025

Gerald B. Smith                                         $2,903           N/A         $153,025

Donald R. Stephens                                      $2,903           N/A         $153,025

Michael W. Wilsey                                       $2,785           N/A         $147,300


- -----------------------------------
(1) Compensation for the fiscal period ending August 31, 2003.

(2) Unless otherwise stated, information is for the fund complex which included
49 funds as of August 31, 2003.

(3) Mr. Coghlan resigned from the board effective August 26, 2003.

(4) Ms. Lepore was appointed to the board on August 26, 2003.

                                                                              51



                                    GNMA FUND



                                                                       Estimated
                                                                      Pension or
                                                                      Retirement        ($)
                                                        ($)            Benefits      Estimated
                                                     Estimated        Accrued as       Total
                                                     Aggregate         Part of      Compensation
                                                    Compensation         Fund        from Fund
  Name of Trustee                                 from the Fund(1)     Expenses      Complex(2)
- -------------------                               ----------------    ----------    -----------
                                                                           
Charles R. Schwab                                          0             N/A                0

John Philip Coghlan(3)                                     0             N/A                0

Dawn Lepore(4)                                             0             N/A                0

Jeffrey M. Lyons                                           0             N/A                0

Mariann Byerwalter                                      $565             N/A         $153,025

Donald F. Dorward                                       $565             N/A         $153,025

William A. Hasler                                       $565             N/A         $153,025

Robert G. Holmes                                        $565             N/A         $153,025

Gerald B. Smith                                         $565             N/A         $153,025

Donald R. Stephens                                      $565             N/A         $153,025

Michael W. Wilsey                                       $565             N/A         $147,300



- -----------------------------------
(1) Compensation for the fiscal period ending August 31, 2003.

(2) Unless otherwise stated, information is for the fund complex which included
    49 funds as of August 31, 2003.

(3) Mr. Coghlan resigned from the board effective August 26, 2003.

(4) Ms. Lepore was appointed to the board on August 26, 2003.

                                                                              52



                  SECURITIES BENEFICIALLY OWNED BY EACH TRUSTEE

The following tables provide information as of December 31, 2002, with respect
to a dollar range of securities beneficially owned by each trustee.

                               TAXABLE BOND FUNDS



                          Dollar Range of Trustee
                     Ownership of Equity Securities in
                                the Fund

                        Short-Term       Total Bond       Aggregate Dollar Range of Trustee
Name of Trustee            Bond            Market           Ownership In the Fund Complex
- ------------------     ------------     --------------    ---------------------------------
                                                 
Charles R. Schwab      $1-$10,000           None                    Over $100,000

Dawn Lepore(1)             None             None                      $1-$10,000

Jeffrey M. Lyons           None             None                    Over $100,000

Mariann Byerwalter         None             None                   $10,001-$50,000

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



                     Dollar Range of Trustee Ownership of Equity Securities in
                                        the Fund
                                                California
                     Short/Inter-               Short/Inter-    California
                       mediate     Long-Term     mediate         Long-Term       Aggregate Dollar Range of
                       Tax-Free    Tax-Free      Tax-Free        Tax-Free            Trustee Ownership
 Name of Trustee      Bond Fund    Bond Fund    Bond Fund        Bond Fund          In the Fund Complex
- ------------------   -----------   ---------   ------------   ---------------    -------------------------
                                                                  
Charles R. Schwab        None         None        None             None               Over $100,000

Dawn Lepore(1)           None         None        None             None                $1-$10,000

Jeffrey M. Lyons         None         None        None             None               Over $100,000

Mariann Byerwalter       None         None        None             None             $10,001-$50,000

Donald F. Dorward        None         None        None        $10,001-$50,000          Over $100,000

William A. Hasler        None         None        None             None             $50,001-$100,000

Robert G. Holmes         None         None        None             None               Over $100,000


- -----------------------------------
(1)Security beneficially owned as of November 7, 2003

                                                                              53





                     Dollar Range of Trustee Ownership of Equity Securities in the Fund

                                                        California
                     Short/Inter                        Short/Inter-        California
                     -mediate          Long-Term         mediate             Long-Term       Aggregate Dollar Range of
                      Tax-Free         Tax-Free          Tax-Free            Tax-Free            Trustee Ownership
 Name of Trustee      Bond Fund        Bond Fund        Bond Fund            Bond Fund          In the Fund Complex
- ------------------   -----------       ---------       ------------       ---------------    -------------------------
                                                                              
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 AND GNMA FUND



                                  Dollar Range of Trustee Ownership
                                   of Equity Security in the Fund          Aggregate Dollar Range of
                                                                               Trustee Ownership
 Name of Trustee                 YieldPlus Fund            GNMA Fund                 Complex
- ----------------------------------------------------------------------------------------------------
                                                                  
Charles R. Schwab                Over $100,000                None               Over $100,000

Dawn Lepore(1)                        None                    None                 $1-$10,000

Jeffrey M. Lyons                      None                    None               Over $100,000

Mariann Byerwalter                    None                    None              $10,001-$50,000

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                Over $100,000                None               Over $100,000


                           DEFERRED COMPENSATION PLAN

Independent trustees may enter into a fee deferral plan. Under this plan,
deferred fees will be credited to an account established by the trust as of the
date that such fees would have been paid to the trustee. The value of this
account will equal the value that the account would have if the fees credited to
the account had been invested in the shares of SchwabFunds(R) selected by the
trustee. Currently, none of the independent trustees has elected to participate
in this plan.

- -------------------
(1) Securities beneficially owned as of November 7, 2003.

                                                                              54


                                 CODE OF ETHICS

The funds, their investment adviser and Schwab have adopted a Code of Ethics
(Code) as required under the 1940 Act. Subject to certain conditions or
restrictions, the Code permits the trustees, directors, officers or advisory
representatives of the funds or the investment adviser or the directors or
officers of Schwab to buy or sell directly or indirectly securities for their
own accounts. This includes securities that may be purchased or held by the
funds. Securities transactions by some of these individuals may be subject to
prior approval of the investment adviser's Chief Compliance Officer or
alternate. Most securities transactions are subject to quarterly reporting and
review requirements.

                DESCRIPTION OF PROXY VOTING POLICY AND PROCEDURES

Charles Schwab Investment Management ("CSIM"), as an investment adviser, is
generally responsible for voting proxies with respect to the securities held in
accounts of investment companies for which it provides discretionary investment
management services. CSIM 's Proxy Committee exercises and documents CSIM's
responsibility with regard to voting of client proxies (the "Proxy Committee").
The Proxy Committee is composed of representatives of CSIM's Compliance, Fund
Administration, Legal and Portfolio Management Departments, and chaired by
CSIM's Chief Investment Officer. The Chairman of the Committee may appoint the
remaining members of the Committee. The Proxy Committee reviews and, as
necessary, may amend periodically these Procedures to address new or revised
proxy voting policies or procedures. The policies stated in these Proxy Voting
Policy and Procedures (the "CSIM Proxy Procedures") pertain to all of CSIM's
clients.

The Boards of Trustees (the "Trustees") of The Charles Schwab Family of Funds,
Schwab Investments, Schwab Capital Trust, and Schwab Annuity Portfolios
(collectively, the "Funds" or "SchwabFunds") has delegated the responsibility
for voting proxies to CSIM through their respective Investment Advisory and
Administration Agreements. The Trustees have adopted these Proxy Procedures with
respect to proxies voted on behalf of the various SchwabFunds portfolios. CSIM
will present amendments to the Trustees for approval. However, there may be
circumstances where the Proxy Committee deems it advisable to amend the Proxy
Procedures between regular SchwabFunds Board meetings. In such cases, the
Trustees will be asked to ratify any changes at the next regular meeting of the
Board.

To assist CSIM in its responsibility for voting proxies and the overall proxy
voting process, CSIM has retained Institutional Shareholder Services ("ISS") as
an expert in the proxy voting and corporate governance area. ISS is an
independent company that specializes in providing a variety of proxy-related
services to institutional investment managers, plan sponsors, custodians,
consultants, and other institutional investors. The services provided by ISS
include in-depth research, global issuer analysis, and voting recommendations as
well as vote execution, reporting and record keeping.

PROXY VOTING POLICY

For investment companies and other clients for which CSIM exercises its
responsibility for voting proxies, it is CSIM's policy to vote proxies in the
manner that CSIM and the Proxy Committee determine will maximize the economic
benefit to CSIM's clients. In furtherance of this policy, the Proxy Committee
has received and reviewed ISS's written proxy voting policies and procedures
("ISS's Proxy Procedures") and has determined that ISS's Proxy Procedures are
consistent with the CSIM Proxy Procedures and CSIM's fiduciary duty with respect
to its clients.
                                                                              55


The Proxy Committee will review any material amendments to ISS's
Proxy Procedures to determine whether such procedures continue to be consistent
with the CSIM Proxy Voting Procedures, and CSIM's fiduciary duty with respect to
its clients.

Except under the circumstances described below, the Proxy Committee will
delegate to ISS responsibility for voting proxies on behalf of CSIM's clients in
accordance with ISS's Proxy Procedures.

For proxy issues that are not addressed by ISS's Proxy Procedures or are
determined by the Proxy Committee or the applicable portfolio manager or other
relevant portfolio management staff to raise significant concerns with respect
to the accounts of CSIM clients, the Proxy Committee will review the analysis
and recommendation of ISS. Examples of factors that could cause a matter to
raise significant concerns include, but are not limited to: issues whose outcome
has the potential to materially affect the company's industry, or regional or
national economy, and matters which involve broad public policy developments
which may similarly materially affect the environment in which the company
operates. The Proxy Committee also will solicit input from the assigned
portfolio manager and other relevant portfolio management staff for the
particular portfolio security. After evaluating all such recommendations, the
Proxy Committee will decide how to vote the shares and will instruct ISS to vote
consistent with its decision. The Proxy Committee has the ultimate
responsibility for making the determination of how to vote the shares in order
to maximize the value of that particular holding.

         Conflicts of Interest. For all proxy issues, whether routine or
non-routine, that present material conflicts of interest between CSIM, and/or
any of its affiliates, and CSIM's clients, CSIM will delegate to ISS
responsibility for voting such proxies in accordance with ISS's Proxy
Procedures.

         Voting Foreign Proxies. CSIM has arrangements with ISS for voting
proxies. However, voting proxies with respect to shares of foreign securities
may involve significantly greater effort and corresponding cost than voting
proxies with respect to domestic securities, due to the variety of regulatory
schemes and corporate practices in foreign countries with respect to proxy
voting. Problems voting foreign proxies may include the following:

         -        proxy statements and ballots written in a foreign language;

         -        untimely and/or inadequate notice of shareholder meetings;

         -        restrictions of foreigner's ability to exercise votes;

         -        requirements to vote proxies in person;

         -        the imposition of restrictions on the sale of securities for a
                  period of time in proximity to the shareholder meeting;

         -        requirements to provide local agents with power of attorney to
                  facilitate CSIM's voting instructions.

In consideration of the foregoing issues, ISS uses its best-efforts to vote
foreign proxies. As part of its ongoing oversight, the Proxy Committee will
monitor the voting of foreign proxies to determine whether all reasonable steps
are taken to vote foreign proxies. If the Proxy Committee determines that the
cost associated with the attempt to vote outweighs the potential benefits
clients may derive from voting, the Proxy Committee may decide not to attempt to
vote.

         Sub-Advisory Relationships. For investment companies or other clients
that CSIM has delegated day-to-day investment management responsibilities to an
investment adviser, CSIM may delegate its responsibility to vote proxies with
respect to such investment companies' or

                                                                              56


other clients' securities. Each Sub-adviser to whom proxy voting responsibility
has been delegated will be required to review all proxy solicitation material
and to exercise the voting rights associated with the securities as it has been
allocated in the best interest of each investment company and its shareholders,
or other client. Prior to delegating the proxy voting responsibility, CSIM will
review each sub-adviser's proxy voting policy to ensure that each Sub-adviser's
proxy voting policy is generally consistent with the maximization of economic
benefits to the investment company or other client.

REPORTING AND RECORD RETENTION

CSIM will maintain, or cause ISS to maintain, records which identify the manner
in which proxies have been voted (or not voted) on behalf of CSIM clients. CSIM
will comply with all applicable rules and regulations regarding disclosure of
its or its clients proxy voting records and procedures.

CSIM will retain all proxy voting materials and supporting documentation as
required under the Investment Advisers Act of 1940 and the rules and regulations
thereunder.

PROXY COMMITTEE QUORUM

Attendance by four members (or their respective designates) constitutes a
quorum.

ISS PROXY VOTING GUIDELINES SUMMARY

Following is a concise summary of ISS's current proxy voting policy guidelines.

1.       AUDITORS

Vote CASE-BY-CASE on shareholder proposals on auditor rotation, taking into
account these factors:

- -        Tenure of the audit firm

- -        Establishment and disclosure of a renewal process whereby the auditor
         is regularly evaluated for both audit quality and competitive price

- -        Length of the rotation period advocated in the proposal

- -        Significant audit-related issues

2.       BOARD OF DIRECTORS

VOTING ON DIRECTOR NOMINEES IN UNCONTESTED ELECTIONS

Generally, vote CASE-BY-CASE.  But WITHHOLD votes from:

- -        Insiders and affiliated outsiders on boards that are not at least
         majority independent

- -        Directors who sit on more than six boards

- -        Compensation Committee members if there is a disconnect between the
         CEO's pay and performance

CLASSIFICATION/DECLASSIFICATION OF THE BOARD

Vote AGAINST proposals to classify the board.

Vote FOR proposals to repeal classified boards and to elect all directors
annually.

                                                                              57


INDEPENDENT CHAIRMAN (SEPARATE CHAIRMAN/CEO)

Vote FOR shareholder proposals asking that the chairman and CEO positions be
separated (independent chairman), unless the company has a strong countervailing
governance structure, including a lead director, two-thirds independent board,
all independent key committees, and established governance guidelines.

MAJORITY OF INDEPENDENT DIRECTORS/ESTABLISHMENT OF COMMITTEES

Vote FOR shareholder proposals asking that a majority or more of directors be
independent unless the board composition already meets the proposed threshold by
ISS's definition of independence.

OPEN ACCESS (SHAREHOLDER RESOLUTION)

Vote CASE-BY-CASE basis, taking into account the ownership threshold proposed in
the resolution and the proponent's rationale.

3.       SHAREHOLDER RIGHTS

SHAREHOLDER ABILITY TO ACT BY WRITTEN CONSENT

Vote against proposals to restrict or prohibit shareholder ability to take
action by written consent.

Vote for proposals to allow or make easier shareholder action by written
consent.

SHAREHOLDER ABILITY TO CALL SPECIAL MEETINGS

Vote against proposals to restrict or prohibit shareholder ability to call
special meetings.

Vote for proposals that remove restrictions on the right of shareholders to act
independently of management.

SUPERMAJORITY VOTE REQUIREMENTS

Vote AGAINST proposals to require a supermajority shareholder vote.

VOTE FOR PROPOSALS TO LOWER SUPERMAJORITY VOTE REQUIREMENTS.

CUMULATIVE VOTING

Vote against proposals to eliminate cumulative voting.

Vote proposals to restore or permit cumulative voting on a case-by-case basis
relative to the company's other governance provisions.

CONFIDENTIAL VOTING

Vote FOR shareholder proposals requesting that corporations adopt confidential
voting, use independent vote tabulators and use independent inspectors of
election. In proxy contests, support confidential voting proposals only if
dissidents agree to the same policy that applies to management.

4.       PROXY CONTESTS

VOTING FOR DIRECTOR NOMINEES IN CONTESTED ELECTIONS

Votes in a contested election of directors must be evaluated on a CASE-BY-CASE
basis, considering the factors that include the long-term financial performance,
management's track record, qualifications of director nominees (both slates),
and an evaluation of what each side is offering shareholders.

                                                                              58


REIMBURSING PROXY SOLICITATION EXPENSES

Vote CASE-BY-CASE. Where ISS recommends in favor of the dissidents, we also
recommend voting for reimbursing proxy solicitation expenses.

5.       POISON PILLS

Vote for shareholder proposals that ask a company to submit its poison pill for
shareholder ratification. Review on a case-by-case basis shareholder proposals
to redeem a company's poison pill and management proposals to ratify a poison
pill.

6.       MERGERS AND CORPORATE RESTRUCTURINGS

Vote CASE-BY-CASE on mergers and corporate restructurings based on such features
as the fairness opinion, pricing, strategic rationale, and the negotiating
process.

7.       REINCORPORATION PROPOSALS

Proposals to change a company's state of incorporation should be evaluated on a
CASE-BY-CASE basis, giving consideration to both financial and corporate
governance concerns, including the reasons for reincorporating, a comparison of
the governance provisions, and a comparison of the jurisdictional laws. Vote FOR
reincorporation when the economic factors outweigh any neutral or negative
governance changes.

8.       CAPITAL STRUCTURE

COMMON STOCK AUTHORIZATION

Votes on proposals to increase the number of shares of common stock authorized
for issuance are determined on a CASE-BY-CASE basis using a model developed by
ISS.

Vote AGAINST proposals at companies with dual-class capital structures to
increase the number of authorized shares of the class of stock that has superior
voting rights.

Vote FOR proposals to approve increases beyond the allowable increase when a
company's shares are in danger of being delisted or if a company's ability to
continue to operate as a going concern is uncertain.

DUAL-CLASS STOCK

Vote AGAINST proposals to create a new class of common stock with superior
voting rights.

Vote FOR proposals to create a new class of nonvoting or subvoting common stock
if:

         -        It is intended for financing purposes with minimal or no
                  dilution to current shareholders

         -        It is not designed to preserve the voting power of an insider
                  or significant shareholder

9.       EXECUTIVE AND DIRECTOR COMPENSATION

ISS applies a quantitative methodology, but for Russell 3000 companies will also
apply a pay-for-performance overlay in assessing equity-based compensation
plans.

Vote AGAINST a plan if the cost exceeds the allowable cap.

Vote FOR a plan if the cost is reasonable (below the cap) unless either of the
following conditions apply:

- -        The plan expressly permits repricing without shareholder approval for
         listed companies; or

- -        There is a disconnect between the CEO's pay and performance (an
         increase in pay and a

                                                                              59


         decrease in performance), the main source for the pay increase is
         equity-based, and the CEO participates in the plan being voted on.

MANAGEMENT PROPOSALS SEEKING APPROVAL TO REPRICE OPTIONS

VOTES ON MANAGEMENT PROPOSALS SEEKING APPROVAL TO REPRICE OPTIONS ARE EVALUATED
ON A CASE-BY-CASE BASIS GIVING CONSIDERATION TO THE FOLLOWING:

- -        Historic trading patterns

- -        Rationale for the repricing

- -        Value-for-value exchange

- -        Option vesting

- -        Term of the option

- -        Exercise price

- -        Participation

EMPLOYEE STOCK PURCHASE PLANS

VOTES ON EMPLOYEE STOCK PURCHASE PLANS SHOULD BE DETERMINED ON A CASE-BY-CASE
BASIS.

Vote FOR employee stock purchase plans where all of the following apply:

         -        Purchase price is at least 85 percent of fair market value

         -        Offering period is 27 months or less, and

         -        Potential voting power dilution (VPD) is 10 percent or less.

VOTE AGAINST EMPLOYEE STOCK PURCHASE PLANS WHERE ANY OF THE OPPOSITE
CONDITIONS OBTAIN.

SHAREHOLDER PROPOSALS ON COMPENSATION

Generally vote CASE-BY-CASE, taking into account company performance, pay level
versus peers, pay level versus industry, and long term corporate outlook. But
generally vote FOR shareholder proposals that:

- -        Advocate performance-based equity awards (indexed options,
         premium-priced options, performance-vested awards), unless the proposal
         is overly restrictive or the company already substantially uses such
         awards

- -        Call for a shareholder vote on extraordinary benefits contained in
         Supplemental Executive Retirement Plans (SERPs).

10.      SOCIAL AND ENVIRONMENTAL ISSUES

These issues cover a wide range of topics, including consumer and public safety,
environment and energy, general corporate issues, labor standards and human
rights, military business, and workplace diversity.

In general, vote CASE-BY-CASE. While a wide variety of factors goes into each
analysis, the overall principal guiding all vote recommendations focuses on how
the proposal will enhance the economic value of the company.

Vote:

- -        FOR proposals for the company to amend its Equal Employment Opportunity
         (EEO) Statement to include reference to sexual orientation, unless the
         change would result in excessive costs for the company.

- -        AGAINST resolutions asking for the adopting of voluntary labeling of
         ingredients or asking

                                                                              60


         for companies to label until a phase out of such ingredients has been
         completed.

               CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES

As of October 28, 2003, the officers and trustees of the Taxable Bond Funds,
Tax-Free Bond Funds, YieldPlus Fund, and GNMA 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 24, 2003, the following represents persons or entities that owned,
of record or beneficially, more than 5% of the outstanding voting securities of
any class of the following funds:

                                                                 
Schwab Short Intermediate Tax-Free Bond Fund(TM)

            Schwab Fund for Charitable Giving                        5.36%

            Michael John Green and Shirley M Green                   5.36%
            4095 Cesar Chavez #12
            San Francisco, CA 94131

Schwab Total Bond Market Fund(TM)

            Charles Schwab & Co. Inc.                                5.15%
            Retirement Services
            101 Montgomery Street
            San Francisco, CA 94104

            Schwab MarketTrack Growth Portfolio                      8.22%
            Schwab MarketTrack Balanced Portfolio                   17.21%
            Schwab MarketTrack Conservative Portfolio               15.06%



                     INVESTMENT ADVISORY AND OTHER SERVICES

                               INVESTMENT ADVISER

Charles Schwab Investment Management, Inc. (CSIM or the investment adviser), a
wholly owned subsidiary of The Charles Schwab Corporation, 101 Montgomery
Street, San Francisco CA 94104, serves as each fund's investment adviser and
administrator pursuant to an Investment Advisory and Administration Agreement
(Advisory Agreement) between it and the trust. Charles Schwab & Co., Inc.
(Schwab), 101 Montgomery Street, San Francisco CA 94104, is an affiliate of the
investment adviser and is the trust's distributor, shareholder services agent
and transfer agent. Charles R. Schwab is the founder, Chairman and Director of
The Charles Schwab Corporation. As a result of his ownership of and interests in
The Charles Schwab Corporation, Mr. Schwab may be deemed to be a controlling
person of the investment adviser and Schwab.

For its advisory and administrative services to each fund, the investment
adviser is entitled to receive a graduated annual fee payable monthly based on
each fund's average daily net assets as described below.

SCHWAB SHORT-TERM BOND MARKET FUND(TM)

SCHWAB TOTAL BOND MARKET FUND(TM)

First $500 million - 0.30%

More than $500 million - 0.22%

                                                                              61


For the fiscal years ended August 31, 2001, 2002 and 2003 the investment
advisory fees incurred by the Schwab Short-Term Bond Market Fund(TM) were $0
(fees were reduced by $818,000), $88,000 (fees were reduced by $1,174,000) and
$820,000 (fees were reduced by $868,000), respectively.

For the fiscal years ended August 31, 2001, 2002 and 2003 the investment
advisory fees incurred by the Schwab Total Bond Market Fund(TM), were $351,000
(fees were reduced by $1,749,000), $447,000 (fees were reduced by $2,127,000)
and $1,533,000 (fees were reduced by $1,169,000), respectively.

The investment adviser and Schwab have contractually guaranteed that, through
November 15, 2004, 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 0.55%, of each fund's average
daily net assets.

YIELDPLUS FUND

First $500 million - 0.35%

More than $500 million - 0.30%

For the fiscal years ended August 31, 2001, 2002 and 2003 the fund paid
investment advisory fees of $795,000, (fees were reduced by $686,000),
$3,985,000, (fees were reduced by $1,185,000) and $5,563,000 (fees were reduced
by $104,000), respectively.

GNMA FUND

For its advisory and administrative services to the fund, the investment adviser
is entitled to receive an annual fee, accrued daily and payable monthly, of
0.45% of the fund's average daily net assets.

For the period between March 1, 2003 and August 31, 2003, the investment
advisory fees incurred by the Schwab GNMA Fund(TM) were $121,000 (fees were
reduced by $121,000).

The investment adviser and Schwab have contractually guaranteed that, through at
least November 15, 2004, the total operating expenses (excluding interest, taxes
and certain non-routine expenses) of the Investor Shares and Select Shares(R) of
the fund will not exceed 0.74% and 0.55%, respectively, of the share class'
average daily net assets.

TAX-FREE BOND FUNDS

First $500 million - 0.30%

More than $500 million - 0.22%

For the fiscal years ended August 31, 2001, 2002 and 2003 the investment
advisory fees incurred by the Schwab Short/Intermediate Tax-Free Bond Fund(TM)
were $56,000 (fees were reduced by $209,000), $110,000 (fees were reduced by
$253,000) and $433,000 (fees were reduced by $37,000), respectively.

For the fiscal years ended August 31, 2001, 2002 and 2003 the investment
advisory fees incurred by the Schwab Long-Term Tax-Free Bond Fund(TM) were
$42,000 (fees were reduced by

                                                                              62


$200,000), $45,000 (fees were reduced by $200,000) and $228,000 (fees were
reduced by $33,000), respectively.

For the fiscal years ended August 31, 2001, 2002 and 2003 the investment
advisory fees incurred by the Schwab California Short/Intermediate Tax-Free Bond
Fund(TM) were $168,000 (fees were reduced by $239,000), $208,000 (fees were
reduced by $262,000) and $512,000 (fees were reduced by $41,000), respectively.

The investment adviser and Schwab have contractually guaranteed that, through
November 15, 2004, 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, 2001, 2002 and 2003 the investment
advisory fees incurred by the Schwab California Long-Term Tax-Free Bond Fund(TM)
were $264,000 (fees were reduced by $312,000), $329,000 (fees were reduced by
$337,000) and $634,000 (fees were reduced by $48,000), respectively.

                                   DISTRIBUTOR

Pursuant to a Distribution Agreement, Schwab is the principal underwriter for
shares of a fund and is the trust's agent for the purpose of the continuous
offering of a fund's shares. Each fund pays the cost of the prospectuses and
shareholder reports to be prepared and delivered to existing shareholders.
Schwab pays such costs when the described materials are used in connection with
the offering of shares to prospective investors and for supplemental sales
literature and advertising. Schwab receives no fee under the Distribution
Agreement.

                     SHAREHOLDER SERVICES AND TRANSFER AGENT

Schwab provides fund information to shareholders, including share price,
reporting shareholder ownership and account activities and distributing a fund's
prospectuses, financial reports and other informational literature about the
funds. Schwab maintains the office space, equipment and personnel necessary to
provide these services. Schwab also distributes and markets SchwabFunds(R) and
provides other services. At its own expense, Schwab may engage third party
entities, as appropriate, to perform some or all of these services.

For the services performed as transfer agent under its contract with a fund,
Schwab is entitled to receive an annual fee, payable monthly from each fund, in
the amount of 0.05% of a fund's average daily net assets. For the services
performed as shareholder services agent under its contract with the Tax-Free
Bond Funds, and the Bond Funds, Schwab is entitled to receive an annual fee,
payable monthly from each fund, in the amount of 0.20% of each fund's average
daily net assets. For the services performed as shareholder services agent under
its contract with the YieldPlus Fund and GNMA Fund, Schwab is entitled to
receive an annual fee, payable monthly from each class of shares of the funds,
in the amount of 0.20% of the Investor Shares' average daily net assets and
0.05% of the Select Shares' average daily net assets.

                          CUSTODIAN AND FUND ACCOUNTANT

PFPC Trust Company, 8800 Tinicum Blvd., Third Floor Suite 200, Philadelphia, PA
19153, serves as custodian for the funds and PFPC, Inc., 400 Bellevue Parkway,
Wilmington, DE 19809,

                                                                              63


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, PricewaterhouseCoopers LLP, audits and
reports on the annual financial statements of each series of the trust and
reviews certain regulatory reports and each fund's federal income tax return.
They also perform other professional accounting, auditing, tax and advisory
services when the trust engages them to do so. Their address is 333 Market
Street, San Francisco, CA 94105. Each fund's audited financial statements for
the fiscal year ending August 31, 2003, 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 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(TM) for the
fiscal years ended August 31, 2002 and 2003 were 150% and 124%, respectively.
The portfolio turnover rates for the Schwab Total Bond Market Fund(TM) for the
fiscal years ended August 31, 2002 and 2003 were 74% and 121%, respectively.

YIELDPLUS FUND

The portfolio turnover rates for the Schwab YieldPlus Fund(R) for the fiscal
years ended August 31, 2002 and 2003 were 42% and 109%, respectively. The
increase in turnover can be attributed to the fund assuming a more defensive
position and allocating more assets to short-term maturities.

GNMA FUND

The portfolio turnover for the Schwab GNMA Fund(TM) for the period between March
1, 2003 and August 31, 2003 was 105%.

TAX-FREE BOND FUNDS

The portfolio turnover rates for the Schwab Short/Intermediate Tax-Free Bond
Fund(TM) for the fiscal years ended August 31, 2002 and 2003 were 28% and 11%,
respectively. The portfolio turnover rates for the Schwab Long-Term Tax-Free
Bond Fund(TM) for the fiscal years ended August 31, 2002 and 2003 were 25% and
22%, respectively.

                                       64


The portfolio turnover rates for the Schwab California Short/Intermediate
Tax-Free Bond Fund(TM) for the fiscal years ended August 31, 2002 and 2003 were
17% and 11%, respectively. The portfolio turnover rates for the Schwab
California Long-Term Tax-Free Bond Fund(TM) for the fiscal years ended August
31, 2002 and 2003 were 34% and 29%, respectively.

                             PORTFOLIO TRANSACTIONS

The Taxable Bond Funds, Tax-Free Bond Funds, YieldPlus Fund and GNMA Fund paid
no brokerage commissions in the last 3 fiscal years.

The investment adviser makes decisions with respect to the purchase and sale of
portfolio securities on behalf of the funds. The investment adviser is
responsible for implementing these decisions, including the negotiation of
commissions and the allocation of principal business and portfolio brokerage.
Purchases and sales of securities on a stock exchange or certain riskless
principal transactions placed on NASDAQ are typically effected through brokers
who charge a commission for their services. Purchases and sales of fixed income
securities may be transacted with the issuer, the issuer's underwriter, or a
dealer. The funds do not usually pay brokerage commissions on purchases and
sales of fixed income securities, although the price of the securities generally
includes compensation, in the form of a spread or a mark-up or mark-down, which
is not disclosed separately. The prices the funds pay to underwriters of
newly-issued securities usually include a commission paid by the issuer to the
underwriter. Transactions placed through dealers who are serving as primary
market makers reflect the spread between the bid and asked prices. The money
market securities in which certain of the funds invest are traded primarily in
the over-the-counter market on a net basis and do not normally involve either
brokerage commissions or transfer taxes. It is expected that the cost of
executing portfolio securities transactions of the funds will primarily consist
of dealer spreads and underwriting commissions.

The investment adviser seeks to obtain the best 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 principal 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

                                                                              65


research services furnished by brokers or dealers in servicing all client
accounts and not all services may necessarily be used in connection with the
account that paid commissions to the broker or dealer providing such services.

The investment adviser may receive a service from a broker or dealer that has
both a "research" and a "non-research" use. When this occurs, the investment
adviser will make a good faith allocation, under all the circumstances, between
the research and non-research uses of the service. The percentage of the service
that is used for research purposes may be paid for with client commissions,
while the investment adviser will use its own funds to pay for the percentage of
the service that is used for non-research purposes. In making this good faith
allocation, the investment adviser faces a potential conflict of interest, but
the investment adviser believes that that the costs of such services may be
appropriately allocated to their anticipated research and non-research uses.

The funds may purchase new issues of securities for clients in a fixed price
offering. In these situations, the seller may be a member of the selling group
that will, in addition to selling securities, provide the investment adviser
with research services. 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.

Registrant may aggregate securities sales or purchases among two or more
clients. Registrant will not aggregate transactions unless it believes such
aggregation is consistent with its duty to seek best execution for each affected
client and is consistent with the terms of the investment advisory agreement for
such client. It is Registrant's policy, to the extent practicable, to allocate
investment opportunities over a period of time on a fair and equitable basis
relative to all clients.

In determining when and to what extent to use Schwab or any other affiliated
broker-dealer as its broker for executing orders for the funds on securities
exchanges, the investment adviser follows procedures, adopted by the Board of
Trustees, that are designed to ensure that affiliated brokerage commissions (if
relevant) are reasonable and fair in comparison to unaffiliated brokerage
commissions for comparable transactions. The Board reviews the procedures
annually and approves and reviews transactions involving affiliated brokers
quarterly.

                             REGULAR BROKER-DEALERS

Each fund's regular broker-dealers during its most recent fiscal year are: (1)
the ten broker-dealers that received the greatest dollar amount of brokerage
commissions from the fund; (2) the ten broker-dealers that engaged as principal
in the largest dollar amount of portfolio transactions; and (3) the ten
broker-dealers that sold the largest dollar amount of the fund's shares. As of
August 31, 2003, certain of the funds held securities issued by their respective
regular broker-dealers, as indicated below.

SCHWAB SHORT-TERM BOND MARKET FUND(TM)



                                                            Value of Fund's Holdings as of
          Regular Broker-Dealer                                     August 31, 2003
- ------------------------------------------------------------------------------------------
                                                         
Bank of America Corp.                                                 $5,020,000
J.P. Morgan Chase & Co.                                               $4,927,000


                                                                              66


                                                                   
Goldman Sachs Group, Inc.                                             $4,027,000
Credit Suisse First Boston International Corp.                        $2,952,000
Morgan Stanley Dean Witter Capital                                    $1,682,000



SCHWAB TOTAL BOND MARKET FUND(TM)



                                                            Value of Fund's Holdings as of
          Regular Broker-Dealer                                     August 31, 2003
- ------------------------------------------------------------------------------------------
                                                         
Countrywide Securities Corporation                                   $12,014,000
Goldman Sachs & Co.                                                  $ 7,461,000
Morgan Stanley Dean Witter Capital                                   $ 6,282,000
Credit Suisse First Boston                                           $ 4,562,000


SCHWAB YIELDPLUS FUND(R)



                                                            Value of Fund's Holdings as of
          Regular Broker-Dealer                                     August 31, 2003
- ------------------------------------------------------------------------------------------
                                                         
Credit Suisse First Boston                                           $42,866,000
Bank of America Mortgage Securities                                  $28,904,000
Deutsche Bank Capital Trust                                          $21,943,000
Lehman Brothers Holdings, Inc.                                       $19,976,000
Morgan Stanley Dean Witter Capital                                   $ 8,375,000
J.P. Morgan Chase & Co.                                              $ 5,409,000


SCHWAB GNMA FUND(TM)



                                                            Value of Fund's Holdings as of
          Regular Broker-Dealer                                     August 31, 2002
- ------------------------------------------------------------------------------------------
                                                         
Morgan Stanley Dean Witter Capital                                    $  773,000


                            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. The minimums may also be waived for investment
programs such as those programs for retirement savings, college savings,
graduation gifts or charitable giving funds.

Each fund may hold special shareholder meetings, which may cause the funds to
incur non-routine expenses. These meetings may be called for purposes such as
electing trustees, changing fundamental policies and amending management
contracts. Shareholders are entitled to one vote for each share owned and may
vote by proxy or in person. Proxy materials will be mailed to

                                                                              67


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 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 2003:
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

                                                                              68


at any time, only orders that are received in good order by the funds' transfer
agent prior to the close of the NYSE's trading session will be executed that day
at the funds' (or classes') share price calculated that day. On any day that the
NYSE closes early the funds reserve the right to advance the time by which
purchase, redemption and exchanges orders must be received by the funds'
transfer agent that day in order to be executed that day at that day's share
price.

As long as the funds or Schwab follow reasonable procedures to confirm that an
investor's telephone or Internet order is genuine, they will not be liable for
any losses the investor may experience due to unauthorized or fraudulent
instructions. These procedures may include requiring a form of personal
identification or other confirmation before acting upon any telephone or
Internet order, providing written confirmation of telephone or Internet orders
and tape recording all telephone orders.

Share certificates will not be issued in order to avoid additional
administrative costs, however, share ownership records are maintained by Schwab.

The funds have made an election with the SEC to pay in cash all redemptions
requested by any shareholder of record limited in amount during any 90-day
period to the lesser of $250,000 or 1% of its net assets at the beginning of
such period. This election is irrevocable without the SEC's prior approval.
Redemption requests in excess of these limits may be paid, in whole or in part,
in investment securities or in cash, as the Board of Trustees may deem
advisable. Payment will be made wholly in cash unless the Board of Trustees
believes that economic or market conditions exist that would make such payment a
detriment to the best interests of the fund. If redemption proceeds are paid in
investment securities, such securities will be valued as set forth in "Pricing
of Shares." A redeeming shareholder would normally incur transaction costs if he
or she were to convert the securities to cash.

The funds are designed for long-term investing. Because short-term trading
activities can disrupt the smooth management of the fund and increase its
expenses, the funds reserve the right to refuse any purchase or exchange order,
or large purchase or exchange orders, including any purchase or exchange order
which appears to be associated with short-term trading activities or "market
timing." Because market timing decisions to buy and sell securities typically
are based on an individual investor's market outlook, including such factors as
the perceived strength of the economy or the anticipated direction of interest
rates, it is difficult for the fund to determine in advance what purchase or
exchange orders may be deemed to be associated with market timing or short-term
trading activities.

Shares of the funds may be held only through a Schwab account or certain
third-party investment providers that have an arrangement with Schwab. If you
close your Schwab account, your fund shares may be redeemed unless you first
transfer them to such a third-party investment provider.

A fund's share price and principal value change, and when you sell your shares
they may be worth less than what you paid for them.

                         EXCHANGING SHARES OF THE FUNDS

Shares of any SchwabFund, including any class of shares, may be sold and shares
of any other SchwabFund or class purchased, provided the minimum investment and
any other requirements of the fund or class purchased are satisfied. Without
limiting this privilege, "an exchange order," which is a simultaneous order to
sell shares of one fund or class and automatically invest the proceeds in
another fund or class, may not be executed between shares of Sweep
Investments(TM)

                                                                              69


and shares of non-Sweep Investments. Shares of Sweep Investments may be bought
and sold automatically pursuant to the terms and conditions of your Schwab
account agreement or by direct order as long as you meet the minimums for direct
investments. In addition, different exchange policies may apply to
SchwabFunds(R) that are bought and sold through third-party investment providers
and the exchange privilege between SchwabFunds may not be available through
third-party investment providers.

The funds and Schwab reserve certain rights with regard to exchanging shares of
the funds. These rights include the right to: (i) refuse any purchase or
exchange order that may negatively impact the fund's operations; (ii) refuse
orders that appear to be associated with short-term trading activities; and
(iii) modify or terminate the exchange privilege upon 60 days' written notice to
shareholders.

                        DELIVERY OF SHAREHOLDER DOCUMENTS

Typically once a year, an updated prospectus will be mailed to shareholders
describing each fund's investment strategies, risks and shareholder policies.
Twice a year, financial reports will be mailed to shareholders describing each
fund's performance and investment holdings. In order to eliminate duplicate
mailings of shareholder documents, each household may receive one copy of these
documents, under certain conditions. This practice is commonly called
"householding." If you want to receive multiple copies, you may write or call
your fund at the address or telephone number on the front of this SAI. Your
instructions will be effective within 30 days of receipt by Schwab.

                                PRICING OF SHARES

Each business day, each share class of a fund calculates its share price, or
NAV, as of the close of the NYSE (generally 4 p.m. Eastern time). This means
that NAVs are calculated using the values of a fund's portfolio securities as of
the close of the NYSE. Such values are required to be determined in one of two
ways: securities for which market quotations are readily available are required
to be valued at current market value; and securities for which market quotations
are not readily available or the investment adviser deems them to be unreliable
are required to be valued at fair value using procedures approved by the Board
of Trustees.

Shareholders of the funds should be aware that because foreign markets are often
open on weekends and other days when the funds are closed, the value of some of
the funds' securities may change on days when it is not possible to buy or sell
shares of the funds.

The funds use approved pricing services to provide values for their portfolio
securities. Current market values are generally determined by the approved
pricing services as follows: securities traded on stock exchanges, excluding the
NASDAQ National Market System, are valued at the last-quoted sales price on the
exchange on which such securities are primarily traded (closing values), or,
lacking any sales, at the mean between the bid and ask prices; securities traded
in the over-the-counter market are valued at the last reported sales price that
day, or, if no sales are reported, at the mean between the bid and ask prices.
Securities listed on the NASDAQ National Market System are valued in accordance
with the NASDAQ Official Closing Price. In addition, securities that are
primarily traded on foreign exchanges are generally valued at the preceding
closing values of such securities on their respective exchanges with these
values then translated into U.S. dollars at the current exchange rate. Fixed
income securities normally are valued based on valuations provided by approved
pricing services. Securities may be fair valued pursuant to procedures approved
by the funds' Board of Trustees when approved pricing services do not

                                                                              70


provide a value for a security, a furnished price appears manifestly incorrect
or events occur prior to the close of the NYSE that materially affect the
furnished price. The Board of Trustees regularly reviews fair value
determinations made by the funds pursuant to the procedures.

                                    TAXATION

                      FEDERAL TAX INFORMATION FOR THE FUNDS

It is each fund's policy to qualify for taxation as a "regulated investment
company" (RIC) by meeting the requirements of Subchapter M of the Internal
Revenue Code of 1986, as amended (the Code). By qualifying as a RIC, a fund
expects to eliminate or reduce to a nominal amount the federal income tax to
which it is subject. If a fund does not qualify as a RIC under the Code, it will
be subject to federal income tax, at regular corporate rates on its net income,
including any net realized capital gains.

The Code imposes a non-deductible excise tax on RICs that do not distribute in a
calendar year (regardless of whether they otherwise have a non-calendar taxable
year) an amount equal to 98% of their "ordinary income" (as defined in the Code)
for the calendar year plus 98% of their net capital gain for the one-year period
ending on October 31 of such calendar year, plus any undistributed amounts from
prior years. The non-deductible excise tax is equal to 4% of the deficiency. For
the foregoing purposes, a fund is treated as having distributed any amount on
which it is subject to income tax for any taxable year ending in such calendar
year.

A fund's transactions in futures contracts, options and certain other investment
activities may be restricted by the Code and are subject to special tax rules.
In a given case, these rules may accelerate income to a fund, defer its losses,
cause adjustments in the holding periods of a fund's assets, convert short-term
capital losses into long-term capital losses or otherwise affect the character
of a fund's income. These rules could therefore affect the amount, timing and
character of distributions to shareholders. A fund will endeavor to make any
available elections pertaining to these transactions in a manner believed to be
in the best interest of a fund and its shareholders.

                 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

                                                                              71


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 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.

                                                                              72


Current federal law limits the types and volume of bonds qualifying for the
federal income tax exemption of interest that may have an effect on the ability
of a fund to purchase sufficient amounts of tax-exempt securities to satisfy the
Code's requirements for the payment of "exempt-interest dividends."

Interest on indebtedness incurred or continued by a shareholder in order to
purchase or carry shares of the funds is not deductible for federal income tax
purposes. Furthermore, these funds may not be an appropriate investment for
persons (including corporations and other business entities) who are
"substantial users" (or persons related to "substantial users") of facilities
financed by industrial development private activity bonds. Such persons should
consult their tax advisors before purchasing shares. A "substantial user" is
defined generally to include "certain persons" who regularly use in their trade
or business a part of a facility financed from the proceeds of such bonds.

                     GENERAL STATE AND LOCAL TAX INFORMATION

Distributions by a fund also may be subject to state, local and foreign taxes,
and its treatment under applicable tax laws may differ from the federal income
tax treatment. Many states grant tax-free status to dividends paid to you from
interest earned on direct obligations of the U.S. government, subject in some
states to minimum investment requirements that must be met by a fund. Investment
in Ginnie Mae or Fannie Mae securities, banker's acceptances, commercial paper
and repurchase agreements collateralized by U.S. government securities do not
generally qualify for such tax-free treatment. The rules on exclusion of this
income are different for corporate shareholders. Shareholders are urged to
consult their tax advisors as to the consequences of these and other state and
local tax rules affecting investments in the funds.

                          CALIFORNIA TAX CONSIDERATIONS

The Schwab California Short/Intermediate Tax-Free Bond Fund(TM) and Schwab
California Long-Term Tax Free Bond Fund(TM) intend to qualify to pay dividends
to shareholders that are exempt from California personal income tax ("California
exempt-interest dividends"). A fund will qualify to pay California
exempt-interest dividends if (1) at the close of each quarter of a fund's
taxable year, at least 50% of the value of a fund's total assets consists of
obligations the interest on which would be exempt from California 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

                                                                              73


of shares of a fund will not be deductible for California personal income tax
purposes if a fund distributes California exempt-interest dividends.

If a fund qualifies to pay dividends to shareholders that are California
exempt-interest dividends, dividends distributed to shareholders will be
considered California exempt-interest dividends if (1) they are designated as
exempt-interest dividends by a fund in a written notice to shareholders mailed
within 60 days of the close of a fund's taxable year and (2) to the extent the
interest received by a fund during the year on California Tax-Exempt Obligations
exceeds expenses of a fund that would be disallowed under California personal
income tax law as allocable to tax-exempt interest if a fund were an individual.
If the aggregate dividends so designated exceed the amount that may be treated
as California exempt-interest dividends, only that percentage of each dividend
distribution equal to the ratio of aggregate California exempt-interest
dividends to aggregate dividends so designated will be treated as a California
exempt-interest dividend.

                         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,             ended August 31,          commencement of
                                       2003                       2003                  operations* to
                                                                                        August 31, 2003
                                                                            
Schwab Short-Term
Bond Market Fund(TM)                   4.16%                      5.66%                     5.19%**
After-tax Returns:
On Distribution                        2.89%                      3.62%                     2.93%**
On Distribution and
Sale                                   2.65%                      3.52%                     2.99%**


                                                                              74


                                                                                   
Schwab Total Bond
Market Fund(TM)                        4.37%                      6.06%                     6.06%**
After-tax Returns:
On Distribution                        2.73%                      3.70%                     3.52%**
On Distribution and
Sale                                   2.81%                      3.68%                     3.54%**



*        November 5, 1991 for the Schwab Short-Term Bond Market Fund and March
         5, 1993 for the Schwab Total Bond Market Fund.

**       Average annual total return for 10 years ended August 31, 2003.

                  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, 2003              August 31, 2003           operations* to
                                                                                        August 31, 2003
                                                                            
Schwab
Short/Intermediate
Tax-Free Bond
Fund(TM)                               2.50%                      4.31%                     4.30%**
After-tax Returns:
On Distribution                        2.50%                      4.31%                     4.30%**
On Distribution and
Sale                                   2.64%                      4.18%                     4.22%**

Schwab Long-Term
Tax-Free Bond Fund(TM)                 4.01%                      4.84%                     5.52%**
After-tax Returns:
On Distribution                        4.01%                      4.81%                     5.47%**
On Distribution and
Sale                                   4.07%                      4.77%                     5.38%**

Schwab California
Short/Intermediate
Tax-Free Bond
Fund(TM)                               2.15%                      4.23%                     4.34%**
After-tax Returns:
On Distribution                        2.15%                      4.23%                     4.34%**
On Distribution and
Sale                                   2.45%                      4.11%                     4.25%**


                                                                              75


                                                                                   
Schwab California
Long-Term Tax-Free
Bond Fund(TM)                          2.14%                      4.67%                     5.35%**
After-tax Returns:
On Distribution                        2.14%                      4.67%                     5.31%**
On Distribution and
Sale                                   2.89%                      4.68%                     5.26%**



*        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.

**       Average annual total return for 10 years ended August 31, 2003.

                    YIELDPLUS FUND STANDARDIZED TOTAL RETURN



                                         Average Annual Total Return          Average Annual Total Return
                                         for 1  year ended August 31,            from commencement of
                                                     2003                    operations* to August 31, 2003
                                                                       
Schwab YieldPlus Fund(R)
     Investor Shares                                 2.95%                               4.48%
After-tax Returns:
On Distribution                                      1.68%                               2.41%
On Distribution and Sale                             1.86%                               2.56%
     Select Shares                                   3.10%                               4.63%
After-tax Returns:
On Distribution                                      1.77%                               2.50%
On Distribution and Sale                             1.95%                               2.66%


*        October 1, 1999 for Schwab YieldPlus Fund.

                       GNMA FUND STANDARDIZED TOTAL RETURN



                                          Total Return for the period
                                          between March 1, 2003 and
                                                August 31, 2003
                                      
Schwab GNMA Fund(TM)
     Investor Shares                                  -1.11%
After-tax Returns:
On Distribution                                       -1.81%
On Distribution and Sale                              -0.72%
     Select Shares                                    -1.11%
After-tax Returns:
On Distribution                                       -1.81%
On Distribution and Sale                              -0.72%


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

                                                                              76


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 percentage may be compared to that
of other mutual funds with similar investment objectives as reported by
independent sources.

                                                                              77


           TAXABLE BOND FUNDS NONSTANDARDIZED CUMULATIVE TOTAL RETURN



                        Fund                            Cumulative Total Return from commencement of
                                                              operations* to August 31, 2003
                                                     
Schwab Short-Term Bond Market Fund(TM)                                    96.26%
Schwab Total Bond Market Fund(TM)                                         95.75%


*        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, 2003
                                                     
Schwab Short/Intermediate Tax-Free Bond
Fund(TM)                                                                  56.75%

Schwab Long-Term Tax-Free Bond Fund(TM)                                   91.02%

Schwab California Short/Intermediate Tax-Free
Bond Fund(TM)                                                             56.87%

Schwab California Long-Term Tax-Free Bond
Fund(TM)                                                                 106.15%


*        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, 2003
                                      
Schwab YieldPlus Fund(R)
     Investor Shares                                             18.72%
     Select Shares                                               19.42%


*        October 1, 1999 for Schwab YieldPlus Fund.

                                                                              78


                GNMA FUND NONSTANDARDIZED CUMULATIVE TOTAL RETURN



                                         Total Return from commencement of operations* to August 31,
                                                                 2003
                                      
Schwab GNMA Fund(TM)
     Investor Shares                                            -1.11%
     Select Shares                                              -1.11%


*        March 1, 2003 for the Schwab GNMA 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, 2003
                                                                
Schwab Short-Term Bond Market  Fund(TM)                                        2.90%

Schwab Total Bond Market Fund(TM)                                              3.04%


                      TAX FREE-BOND FUNDS 30-DAY SEC YIELD



                   Fund                                            30-day period ended August 31, 2003
                                                                
Schwab Short/Intermediate Tax-Free Bond Fund(TM)                               2.32%

Schwab Long-Term Tax-Free Bond Fund(TM)                                        4.20%

Schwab California Short/Intermediate Tax-Free
Bond Fund(TM)                                                                  2.34%

Schwab California Long-Term Tax-Free Bond
Fund(TM)                                                                       4.47%

                         YIELDPLUS FUND 30-DAY SEC YIELD



                                                                   30-day period ended August 31, 2003
                                                                
Schwab YieldPlus Fund(R)
     Investor Shares                                                            2.44%
     Select Shares                                                              2.59%


                                                                              79


                           GNMA FUND 30-DAY SEC YIELD



                                                                 30-day period ended August 31, 2003
                                                              
Schwab GNMA Fund(TM)
     Investor Shares                                                            0.88%
     Select Shares                                                              0.88%


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, 2003
                                                              
Schwab Short/Intermediate Tax-Free Bond
Fund(TM)                                                                        3.57%

Schwab Long-Term Tax-Free Bond Fund(TM)                                         6.46%

Schwab California Short/Intermediate Tax-Free
Bond Fund(TM)                                                                   3.97%

Schwab California Long-Term Tax-Free Bond
Fund(TM)                                                                        7.58%


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 35.0% 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 41.05% 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.

                                                                              80


                             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, 2002. 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
Dec. 31, 2002                            10.25                                8.12


                                                                              81


                   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.

                                                                              82


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

                                                                              83


         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.

                                                                              84


                          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.

                                                                              85