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STATEMENT OF ADDITIONAL INFORMATION
SCHWAB INVESTMENTS
SCHWAB SHORT-TERM BOND MARKET INDEX FUND
SCHWAB TOTAL BOND MARKET INDEX FUNDTM
NOVEMBER 15, 1999
AS AMENDED JUNE 1, 2000
The Statement of Additional Information (SAI) is not a prospectus. It should be
read in conjunction with a fund's prospectus dated November 15, 1999 (as amended
from time to time).
To obtain a copy of the prospectus, please contact SchwabFunds(R) at
800-435-4000, day or night, or write to the fund at P.O. Box 7575, San
Francisco, CA 94120-7575. For TDD service call 800-345-2550, day or night. The
prospectus also may be available on the Internet at:
http://www.schwab.com/schwabfunds.
The funds are a series of Schwab Investments (the trust).
The funds' most recent annual report is a separate document supplied with the
SAI and includes the funds' audited financial statements, which are incorporated
by reference into this SAI.
Prior to November 1, 1997, Schwab Short-Term Bond Market Index Fund was named
Schwab Short/Intermediate Government Bond Index Fund, and Schwab Total Bond
Market Index Fund was named Schwab Long-Term Government Bond Fund.
TABLE OF CONTENTS
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INVESTMENT OBJECTIVE, SECURITIES, RISKS AND LIMITATIONS ................................... 2
MANAGEMENT OF THE FUNDS ................................................................... 25
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES ....................................... 28
INVESTMENT ADVISORY AND OTHER SERVICES .................................................... 28
BROKERAGE ALLOCATION AND OTHER PRACTICES .................................................. 30
DESCRIPTION OF THE TRUST .................................................................. 31
PURCHASE, REDEMPTION, DELIVERY OF SHAREHOLDER REPORTS
AND PRICING OF SHARES ..................................................................... 32
TAXATION .................................................................................. 33
CALCULATION OF PERFORMANCE DATA ........................................................... 34
APPENDIX - RATINGS OF INVESTMENT SECURITIES ............................................... 37
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INVESTMENT OBJECTIVE, SECURITIES, RISKS AND LIMITATIONS
INVESTMENT OBJECTIVE
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.
There is no guarantee a fund will achieve its investment objective.
The indexes are the Lehman Brothers Mutual Fund Short (1-5) Government/Corporate
Index for the Schwab Short-Term Bond Index Fund (the Short-Term Index), and the
Lehman Brothers Aggregate Bond Index for the Schwab Total Bond Market Index Fund
(the 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 Aggregate Bond Index is a market-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 $100 million and a fixed interest rate.
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
company means the vote, at an annual or a special meeting of shareholders of a
fund where (a) 67% 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 the less.
The following descriptions of investment securities, risks and limitations
supplement those set forth in the prospectus and may be changed without
shareholder approval unless otherwise noted. Also, policies and limitations that
state a maximum percentage of assets that may be invested in a security or other
asset, or that set forth a quality standard, shall be measured immediately after
and as a result of a fund's acquisition of such security or asset unless
otherwise noted. Any subsequent change in values, net assets or other
circumstances will not be considered when determining whether the investment
complies with a fund's investment policies and limitations. Not all investment
securities or techniques discussed below are eligible investments for each fund.
Each fund will invest in securities or engage in techniques that are intended to
help achieve its investment objective.
INVESTMENT SECURITIES AND RISKS
BANKERS' ACCEPTANCES or notes are credit instruments evidencing a bank's
obligation to pay a draft drawn on it by a customer. These instruments reflect
the obligation both of the bank and of the drawer to pay the full amount of the
instrument upon maturity. A fund will invest only in bankers' acceptances of
banks that have capital, surplus and undivided profits in excess of $100
million.
BOND SUBSTITUTION is a strategy whereby a fund may, from time to time,
substitute one type of investment-grade bond for another. This means that, as an
example, a fund may have a higher
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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.
Each fund will restrict its corporate bond substitutions to issues with less
than 4 years remaining to maturity, and in the aggregate to no more than 15% of
its net assets.
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. Each fund may borrow money
from banks and make other investments or engage in other transactions
permissible under the 1940 Act which may be considered a borrowing (such as
mortgage dollar rolls and reverse repurchase agreements). However, each fund may
not purchase securities when bank borrowings exceed 5% of a fund's total assets.
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.
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. For example, the automobile industry may have a greater exposure to a
single factor, such as an increase in the price of oil, which may adversely
affect the sale of automobiles and, as a result, the value of the industry's
securities. Based on the primary characteristics of non-U.S. (foreign) banks,
each fund has identified each foreign country as a separate bank industry for
purposes of a fund's concentration policy. Each fund will limit its investments
in securities issued by foreign banks in each country to less than 25% of its
net assets.
Based on the primary characteristics of the various types of asset-backed
securities, for purposes of a fund's concentration policy, the following
asset-backed securities industries have been selected: credit card receivables,
automobile receivables, trade receivables and diversified financial assets. Each
fund will limit its investments in each such industry to less than 25% of its
net assets.
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
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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.
CREDIT AND LIQUIDITY SUPPORTS may be employed by issuers or the 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
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rates, the creditworthiness of the issuer and general market liquidity (market
risk). Investment-grade debt securities are considered medium- or/and
high-quality securities, although some still possess varying degrees of
speculative characteristics and risks. Debt securities rated below
investment-grade are riskier, but may offer higher yields. These securities are
sometimes referred to as high yield securities or "junk bonds."
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 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, the fund may experience an increase in
share price volatility. This also could lengthen the fund's overall average
effective maturity.
DEPOSITARY RECEIPTS include American or European Depositary Receipts (ADRs or
EDRs), Global Depositary Receipts or Shares (GDRs or GSSs) 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.
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. Each fund is a diversified mutual fund.
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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 and call features into one measure. Duration management is one of
the fundamental tools used by the investment adviser.
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.
Futures, options, and options on futures have durations which, in general, are
closely related to the duration of the securities which underlie them. Holding
long futures or call option positions will lengthen the duration of a fund's
portfolio by approximately the same amount of time that holding an equivalent
amount of the underlying securities would.
Short futures or put option positions have durations roughly equal to the
negative duration of the securities that underlie these positions, and have the
effect of reducing portfolio duration by approximately the same amount of time
that selling an equivalent amount of the underlying securities would.
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 the 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.
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
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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.
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.
In addition to the risks discussed above, it is unforeseeable what risk, if any,
may exist to investments as a result of the conversion of the 11 of the 15
Economic Union Member States from their respective local currency to the
official currency of the Economic and Monetary Union (EMU). As of January 3,
1999, the euro became the official currency of the EMU, the rate of exchange was
set between the euro and the currency of each converting country and the
European Central Bank, all national central banks and all stock exchanges and
depositories began pricing, trading and settling in euro even if the securities
traded are not denominated in euro. Each securities transaction that requires
converting to euro may involve rounding that could affect the value of the
security converted. In addition, issuers of securities that require converting
may experience increased costs as a result of the conversion, which may affect
the value of their securities. It is possible that uncertainties related to the
conversion will affect investor expectations and cause investments to shift from
or to European countries, thereby making the European market less liquid or more
expensive. All of these factors could affect the value of a fund's investments
and/or increase its expenses. While the investment adviser has
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taken steps to minimize the impact of the conversion on a fund, it is not
possible to know precisely what impact the conversion will have on a fund, if
any, nor is it possible to eliminate the risks completely.
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, the fund may engage in forward foreign currency exchange contracts in
order to secure exchange rates for portfolio securities purchased or sold, but
waiting 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 the fund settles
its securities transactions in the future.
The 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, the 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 the fund
expects to purchase).
Buying and selling foreign currency exchange contracts involve costs and may
result in losses. The ability of the 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 the fund 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 the fund to sustain
losses, which will prevent it from achieving a complete hedge or expose it to
risk of foreign exchange loss. Losses to the fund will affect its performance.
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
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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, the fund will 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 the fund had instead
transacted in the underlying securities directly. There also is the risk of
losing any margin payments held by a broker in the event of its bankruptcy.
Additionally, a fund incurs transaction costs (i.e. brokerage fees) when
engaging in futures trading.
When interest rates are rising or securities prices are falling, a fund may
seek, through the sale of futures contracts, to offset a decline in the value of
its current portfolio securities. When rates are falling or prices are rising, a
fund, through the purchase of futures contracts, may attempt to secure better
rates or prices than might later be available in the market when they effect
anticipated purchases. Similarly, a fund may sell futures contracts on a
specified currency to protect against a decline in the value of that currency
and its portfolio securities that are denominated in that currency. Each fund
may purchase futures contracts on a foreign currency to fix the price in U.S.
dollars of a security denominated in that currency that a fund has acquired or
expects to acquire.
Futures contracts normally require actual delivery or acquisition of an
underlying security or cash value of an index on the expiration date of the
contract. In most cases, however, the contractual obligation is fulfilled before
the date of the contract by buying or selling, as the case may be, identical
futures contracts. Such offsetting transactions terminate the original contracts
and cancel the obligation to take or make delivery of the underlying securities
or cash. There may not always be a liquid secondary market at the time a fund
seeks to close out a futures position. If a fund is unable to close out its
position and prices move adversely, a fund would have to continue to make daily
cash payments to maintain its margin requirements. If a fund had insufficient
cash to meet these requirements it may have to sell portfolio securities at a
disadvantageous time or incur extra costs by borrowing the cash. Also, a fund
may be required to make or take delivery and incur extra transaction costs
buying or selling the underlying securities. Each fund would seek to reduce the
risks associated with futures transactions by buying and selling futures
contracts that are traded on national exchanges or for which there appears to be
a liquid secondary market.
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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. In
addition, the high yield market is relatively new and its growth has paralleled
a long period of economic expansion and an increase in merger, acquisition and
leveraged buyout activity. 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.
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.
INDEXING STRATEGIES involve tracking the investments and, therefore, performance
of an index. Each fund normally will invest 65% of its total assets in the
securities of its index. Moreover, each fund will invest so that its portfolio
performs similarly to that of its index. Each fund tries to generally match its
holdings in a particular security to its weight in the index. Each fund will
seek a correlation between its performance and that of its index of 0.90 or
better. A perfect correlation of 1.0 is unlikely as the funds incur operating
and trading expenses unlike their indices. A fund may rebalance its holdings in
order to track its index more closely. In the event its intended correlation is
not achieved, the board of trustees will consider alternative arrangements for a
fund.
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
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(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 Depository 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 treatment 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.
LENDING of portfolio securities is a common practice in the securities industry.
A fund may engage in security lending arrangements with the primary objective of
increasing its income. For example, a fund may receive cash collateral and it
may invest it in short-term, interest-bearing obligations, but will do so only
to the extent that it will not lose the tax treatment available to mutual funds.
Lending portfolio securities involves risks that the borrower may fail to return
the securities or provide additional collateral. Also, voting rights with
respect to the loaned securities may pass with the lending of the securities and
efforts to call such securities promptly may be unsuccessful, especially for
foreign securities.
A fund may loan portfolio securities to qualified broker-dealers or other
institutional investors provided: (1) the loan is secured continuously by
collateral consisting of U.S. government securities, letters of credit, cash or
cash-equivalents or other appropriate instruments maintained on a daily
marked-to-market basis in an amount at least equal to the current market value
of the securities loaned; (2) a fund may at any time call the loan and obtain
the return of the securities loaned; (3) a fund will receive any interest or
dividends paid on the loaned securities; and (4) an aggregate market value of
securities loaned will not at any time exceed one-third of the total assets of a
fund, including collateral received from the loan (at market value computed at
the time of the loan).
Although voting rights with respect to loaned securities pass to the borrower,
the lender retains the right to recall a security (or terminate a loan) for the
purpose of exercising the security's voting rights. Efforts to recall such
securities promptly may be unsuccessful, especially for foreign securities or
thinly traded securities such as small-cap stocks. In addition, because
recalling a security may involve expenses to a fund, it is expected that a fund
will do so only where the items being voted upon are, in the judgment of the
investment adviser, either material to the economic value of the security or
threaten to materially impact the issuer's corporate governance policies or
structure.
LOAN INTERESTS and other direct debt instruments or interests therein may be
acquired by the 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
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not always the Agent ("Collateral Bank"), holds collateral (if any) on behalf of
the lenders. 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. The fund may also acquire
loan interests under which the fund derives its rights directly from the
borrower. Such loan interests are separately enforceable by the fund against the
borrower and all payments of interest and principal are typically made directly
to the fund from the borrower. In the event that the 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 Collateral Bank for their mutual
benefit. The fund may not act as an Agent, a Collateral Bank, a guarantor or
sole negotiator or structurer with respect to a loan.
The investment adviser will analyze and evaluate the financial condition of the
borrower in connection with the acquisition of any Loan Interest. The investment
adviser also analyzes and evaluates the financial condition of the Agent and, in
the case of Loan Interests in which the fund does not have privity with the
borrower, those institutions from or through whom the 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.
The fund will generally rely upon the Agent or Intermediate Participant to
receive and forward to the fund its portion of the principal and interest
payments on the loan. Furthermore, unless under the terms of a participation
agreement the fund has direct recourse against the borrower, the 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,
the Fund will perform such tasks on its own behalf, although a Collateral Bank
will typically hold any collateral on behalf of the Fund and the other pursuant
to the applicable loan agreement.
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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 the Fund were
determined to be subject to the claims of the Agent's general creditors, the
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 the fund does not receive a
scheduled interest or principal payment on such indebtedness, the fund's share
price and yield could be adversely affected. Loans that are fully secured offer
the 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.
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 later 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 and 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 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.
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.
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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 and collateralized mortgage obligations. MBS may be
issued or guaranteed by U.S. government agencies or instrumentalities, such as
the Government National Mortgage Association and the Fannie Mae or Freddie Mac,
or by private issuers, generally originators and investors in mortgage loans,
including savings associations, mortgage banks, commercial banks, and special
purpose entities (collectively, "private lenders"). Mortgage-backed securities
issued by private lenders may be supported by pools of mortgage loans or other
mortgage-backed securities that are guaranteed, directly or indirectly, by the
U.S. government or one of its agencies or instrumentalities, or they may be
issued without any governmental guarantee of the underlying mortgage assets but
with some form of credit enhancement.
Asset-backed securities (ABS) have structural characteristics similar to
mortgage-backed securities. Asset-backed debt obligations 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 asset-backed
debt obligations may be supported by credit enhancements including letters of
credit, an insurance guarantee, reserve funds and overcollateralization.
The rate of principal payment on MBS and ABS generally depends on the rate of
principal payments received on the underlying assets which in turn may be
affected by a variety of economic and other factors. As a result, the price and
yield on any MBS or ABS is difficult to predict with precision and price and
yield to maturity may be more or less than the anticipated yield to maturity. If
a fund purchases these securities at a premium, a prepayment rate that is faster
than expected will reduce yield to maturity, while a prepayment rate that is
slower than expected will have the opposite effect of increasing the yield to
maturity. Conversely, if a fund purchases these securities at a discount, a
prepayment rate that is faster than expected will increase yield to maturity,
while a prepayment rate that is slower than expected will reduce yield to
maturity. Amounts available for reinvestment by a fund are likely to be greater
during a period of declining interest rates and, as a result, are likely to be
reinvested at lower interest rates than during a period of rising interest
rates.
While many MBS and ABS are issued with only one class of security, many are
issued in more than one class, each with different payment terms. Multiple class
MBS and ABS are issued as a method of providing credit support, typically
through creation of one or more classes whose right to payments on the security
is made subordinate to the right to such payments of the remaining class or
classes. In addition, multiple classes may permit the issuance of securities
with payment terms, interest rates, or other characteristics differing both from
those of each other and from those of the underlying assets. Examples include
stripped securities, which are MBS and ABS entitling the holder to
disproportionate interest or principal compared with the assets backing the
security, and securities with classes having characteristics different from the
assets backing the securities, such as a security with floating interest rates
with assets backing the securities having
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fixed interest rates. The market value of such securities 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.
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 options written by
the portfolios will be covered, which means that the portfolios will own the
securities subject to the option so long as the option is outstanding.
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, 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. The purpose of writing such options is to
generate additional income for a fund. However, in return for the option
premium, a fund accepts the risk that it may be required to purchase the
underlying securities at a price in excess of the securities market value at the
time of purchase.
A fund may purchase and write put and call options on any securities in which it
may invest or any securities index based on securities in which it may invest. A
fund may purchase and write such options on securities that are listed on
domestic or foreign securities exchanges or traded in the over-the-counter
market. Like futures contracts, option contracts are rarely exercised. Option
buyers usually sell the option before it expires. Option writers may terminate
their obligations under a written call or put option by purchasing an option
identical to the one it has written. Such purchases are referred to as "closing
purchase transactions." A fund may enter into closing sale transactions in order
to realize gains or minimize losses on options it has purchased or written.
An exchange-traded currency option position may be closed out only on an options
exchange that provides a secondary market for an option of the same series.
Although a fund generally will purchase or write only those options for which
there appears to be an active secondary market, there is no assurance that a
liquid secondary market will exist for any particular option or at any
particular time. If a fund is unable to effect a closing purchase transaction
with respect to options it has written, it will not be able to sell the
underlying securities or dispose of assets 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
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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 Securities and Exchange Commission (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 a fund and the prices of the options,
possible lack of a liquid secondary markets, and the resulting inability to
close such positions prior to their maturity dates.
A fund may write or purchase an option only when the market value of that
option, when aggregated with the market value of all other options transactions
made on behalf of a fund, does not exceed 5% of its total assets.
PREFERRED STOCKS are nonvoting equity securities that pay a stated fixed or
variable rate dividend. Although the preferred shareholders have no right to
receive dividends, they must receive the stated rate prior to any dividends
being paid on the common stock. Since the preferred stockholder 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 stockholders;
preferred stockholders have claims senior to those of common stockholders.
Preferred stocks are rated like fixed income securities and the fund will only
invest in investment-grade preferred stock that has a call feature that the
investment manager expects to be exercised by the issuer on the call date or
that has a specified redemption date.
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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 the fund's attempt to exercise
the put, the 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 the fund. This
also could lengthen the fund's overall average effective maturity. Standby
commitments are types of puts.
QUALITY OF INVESTMENTS will be principally investment-grade for each fund's
assets. Investment-grade quality 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.
However, such downgrade would not require the investment adviser to sell the
security on behalf of a fund. Sometimes lower-quality securities may be
downgraded to an even lower quality. If any of a fund's lower-quality securities
were down-graded to below the sixth rating category, the investment adviser will
promptly sell the security on behalf of the fund.
The investment adviser may also elect to purchase high-yield securities for
either 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 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 the funds' exposure in this regard, the investment manager will not
purchase for the funds high-yield securities that are rated (at the time of
purchase) below B or the equivalent by Moody's or S&P. In addition, if a
high-yield security that is held by either fund is downgraded to below B or the
equivalent by Moody's or S&P, the investment adviser will promptly dispose of
the security.
REPURCHASE AGREEMENTS involve a fund buying securities (usually U.S. government
securities) from a seller and simultaneously agreeing to sell them back at an
agreed-upon price (usually higher) and time. There are risks that losses will
result if the seller does not perform as agreed. Under certain circumstances,
repurchase agreements that are fully collateralized by U.S. government
securities may be deemed to be investments in U.S. government securities
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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 portfolios may be increased if
qualified institutional buyers become uninterested in purchasing these
securities.
REVERSE REPURCHASE AGREEMENTS AND MORTGAGE DOLLAR ROLLS may be used by the fund.
The 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, the fund
would sell a security and enter into an agreement to repurchase the security at
a specified future date and price. The fund generally retains the right to
interest and principal payments on the security. Because the fund receives cash
upon entering into a reverse repurchase agreement, it may be considered a
borrowing. When required by guidelines of the SEC, the fund will set aside
permissible liquid assets in a segregated account to secure its obligations to
repurchase the security.
The fund also may enter into mortgage dollar rolls, in which the fund would sell
MBS for delivery in the current month and simultaneously contract to purchase
substantially similar securities on a specified future date. While the fund
would forego principal and interest paid on the MBS during the roll period, the
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. The fund also could be compensated through the
receipt of fee income equivalent to a lower forward price. At the time the fund
would enter into a mortgage dollar roll, it would set aside permissible liquid
assets 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 the fund.
The mortgage dollar rolls and reverse repurchase agreements entered into by the
fund may be used as arbitrage transactions in which the fund will maintain an
offsetting position in short duration investment grade debt obligations. Since
the 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 the fund than those associated with other
types of leverage. There can be no assurance that the fund's use of the cash it
receives from a mortgage dollar roll will provide a positive return.
RISK MANAGEMENT TECHNIQUES used by a fund may include buying and selling futures
and options contracts, entering into total return, asset and credit swaps,
credit-linked notes and wrap agreements and investing in various types of
derivative instruments. A fund may use risk management techniques, including
derivative instruments, for any lawful purpose consistent with its investment
objective, such as hedging or managing risk. Derivative instruments are commonly
defined to include securities or contracts whose values depend on (or "derive"
from) the value of one or more other assets such as securities, currencies, or
commodities. These "other assets" are commonly referred to as "underlying
assets."
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
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contracts, as well as exchange-traded futures. Option-based derivatives include
privately negotiated, over-the-counter ("OTC") options (including caps, floors,
collars, and options on forward and swap contracts) and exchange-traded options
on futures. Diverse types of derivatives may be created by combining options or
forward contracts in different ways, and applying these structures to a wide
range of underlying assets.
Risk management strategies include investment techniques designed to facilitate
the sale of portfolio securities, manage the average effective maturity 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 the SAI,
the investment adviser expects to discover additional derivative instruments and
other hedging or risk management techniques. The investment adviser may utilize
these new derivative instruments and techniques to the extent that they are
consistent with a fund's investment objective and permitted by a fund's
investment limitations, operating policies, and applicable regulatory
authorities.
SECURITIES 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 Securities
and Exchange Commission (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. In addition, a fund intends to
vote any proxies of underlying mutual funds in accordance with the instructions
received, or in the same proportion as the vote of all other shareholders of the
underlying mutual fund.
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 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 fund
assets to substantial risk to the investment principal. These funds, while not
regulated by the SEC like mutual funds, may be indirectly supervised by the
sources of their assets, which tend to be commercial and investment banks and
other financial institutions. Investments in these funds also may be more
difficult to sell, which could cause losses to a fund. For example, hedge funds
typically require investors to keep their investment in a hedge fund for some
period of time, such as one month. This means
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<PAGE> 20
investors would not be able to sell their shares of a hedge fund until such time
had past.
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. The 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 the 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 the fund does not own, but which is used as a benchmark. The risk to the
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 the 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.
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 a Federal Reserve Bank are obligations of the U.S. Treasury.
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 the 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, the fund must be prepared to make such payments when they
are due. In order to help minimize risks, a fund will 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 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.
U.S. GOVERNMENT SECURITIES are issued by the U.S. Treasury or issued or
guaranteed by the U.S. government or its agencies or instrumentalities. U.S.
Treasury securities include bills, notes and bonds and are backed by the full
faith and credit of the United States. Not all U.S. government securities are
backed by the full faith and credit of the United States. Securities issued by
government agencies or instrumentalities include obligations of the following:
The Farm Credit System, Small Business Administration, and the Government
National Mortgage Association ("GNMA" or "Ginnie Mae"), including GNMA
certificates and mortgage-backed securities, whose securities are supported by
the full faith and credit of the United States; the Federal
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<PAGE> 21
Home Loan Banks and the Tennessee Valley Authority, whose securities are
supported by the right to borrow from the U.S. Treasury; Freddie Mac (formerly
known as the Federal Home Loan Mortgage Association or "FHLMC") and Fannie Mae
(formerly known as the Federal National Mortgage Association or "FNMA"), or the
Student Loan Marketing Association ("Sallie Mae" or "SLMA"), whose securities
are supported by the discretionary authority of the U.S. government to purchase
certain obligations of the agency or instrumentality.
There can be no assurance that the U.S. government will provide full financial
support to U.S. government-sponsored agencies or instrumentalities if the U.S.
government is not obligated to do so under law. While U.S. government
securities, including U.S. Treasury securities, are among the safest securities,
like other fixed-income securities, they are sensitive to interest rate changes,
which will cause the yield and value of such securities 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 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 the fund will lose the purchase price it
paid for the warrant and the right to purchase the underlying security.
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 or income earned on the covered assets. The rate
also can be impacted by defaulted securities and by purchase and redemption
levels in a fund. A fund also pays a fee under the agreement, which reduces the
rate as well.
Wrap agreements may be used as a risk management technique intended to help
minimize fluctuations in a fund's NAV. However, a fund's NAV will typically
fluctuate at least minimally, and may fluctuate more at times when interest
rates are fluctuating. Additionally,
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<PAGE> 22
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. 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.
INVESTMENT LIMITATIONS
The following investment limitations are fundamental investment policies and
restrictions and may be changed only by vote of a majority of the fund's
outstanding voting shares.
EACH FUND MAY:
1) Lend or borrow money to the extent permitted by the Investment Company
Act of 1940 or rule or regulations thereunder, as such statute, rules
or regulations may be amended from time to time.
2) Pledge, mortgage or hypothecate any of its assets to the extent
permitted by the Investment Company Act of 1940 or the rules or
regulations thereunder, as such statute, rules or regulations may be
amended from time to time.
3) Not concentrate investments in a particular industry or group of
industries, or within one state (except to the extent that the index
which each fund seeks to track is also so concentrated) as
concentration is defined under the Investment Company Act of 1940 or
the rules or regulations thereunder, as such statute, rules or
regulations may be amended from time to time.
4) Underwrite securities to the extent permitted by the Investment Company
Act of 1940 or the rules or regulations thereunder, as such statute,
rules or regulations may be amended from time to time.
5) Not, as to 75% of the fund's assets, purchase securities of any issuer
(other than obligations of, or guaranteed by, the U.S. government, its
agencies or instrumentalities) if, as a result more than 5% of the
value of its total assets would be invested in the securities of such
issuer.
6) Not invest for the purpose of exercising control or management of
another issuer.
7) Not purchase securities of other investment companies, except as
permitted by the Investment Company Act of 1940.
8) 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.
9) 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.
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<PAGE> 23
THE FOLLOWING DESCRIPTIONS OF THE 1940 ACT MAY ASSIST INVESTORS IN
UNDERSTANDING THE ABOVE POLICIES AND RESTRICTIONS.
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 hypothocating 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.
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 segregation of assets.
The following are non-fundamental investment policies and restrictions and may
be changed by the board of trustees. Each fund may not:
1) Purchase more than 10% of any class of securities of any issuer if, as
a result of such purchase, it would own more than 10% of such issuer's
outstanding voting securities.
2) Invest more than 5% of its total assets in securities of issuers (other
than obligations of, or guaranteed by the U.S. government, its agencies
or instrumentalities) that with their predecessors have a record of
less than three years continuous operation.
3) Purchase securities that would cause more than 5% of its net assets to
be invested in restricted securities, excluding restricted securities
eligible for resale pursuant to Rule 144A under the Securities Act of
1933 that have been determined to be liquid under procedures adopted by
the trust's board of trustees based upon the trading markets for the
securities.
4) Invest more than 5% of its net assets in warrants, valued at the lower
of cost or market, and no more than 40% of this 5% may be invested in
warrants that are not listed on the New York Stock Exchange or the
American Stock Exchange, provided, however, that for purposes of this
restriction, warrants acquired by a fund in units or attached to other
securities are deemed to be without value.
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<PAGE> 24
5) Purchase puts, calls, straddles, spreads or any combination thereof if
by reason of such purchase the value of its aggregate investment in
such securities would exceed 5% of the fund's total assets.
6) Make short sales, except for short sales against the box.
7) Purchase or sell interests in oil, gas or other mineral development
programs or leases, although it may invest in companies that own or
invest in such interests or leases.
8) Purchase securities on margin, except such short-term credits as may be
necessary for the clearance of purchases and sales of securities.
9) Lend money to any person, except that each fund may (1) purchase a
portion of an issue of short-term debt securities or similar
obligations (including repurchase agreements) that are publicly
distributed or customarily purchased by institutional investors, and
(2) lend its portfolio securities.
10) Borrow money, except from banks for temporary purposes to satisfy
redemption requests or for extraordinary or emergency purposes and then
only in an amount not to exceed one-third of the value of its total
assets (including the amount borrowed), provided that each fund will
not purchase securities while borrowings represent more than 5% of its
total assets.
11) Pledge, mortgage or hypothecate any of its assets, except that to
secure allowable borrowing, each fund may do so with respect to no more
than one-third of the value of its total assets.
12) Underwrite securities issued by others, except to the extent it may be
deemed to be an underwriter, under the federal securities laws, in
connection with the disposition of securities from its investment
portfolio.
13) Purchase securities of any other issuer (other than U.S. government
securities ) if, as a result, more than 25% of its total assets would
be invested in the securities if an issuer from a single industry or
group of industries.
14) Purchase the securities of any issuer if, as a result more than 15% of
its net assets would be invested in illiquid securities.
15) Purchase or sell commodities or real estate, including interests in
real estate limited partnerships, provided that each fund may (1)
purchase securities of companies that deal in real estate or interests
therein, and (2) purchase or sell futures contracts, options contracts,
equity index participations and index participations contracts.
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<PAGE> 25
MANAGEMENT OF THE FUNDS
The officers and trustees, their principal occupations during the past five
years and their affiliations, if any, with The Charles Schwab Corporation,
Charles Schwab & Co., Inc. and Charles Schwab Investment Management, Inc., are
as follows:
<TABLE>
<CAPTION>
NAME/DATE POSITION(S) WITH PRINCIPAL OCCUPATIONS & AFFILIATIONS
OF BIRTH THE TRUST
--------- ---------------- ------------------------------------
<S> <C> <C>
CHARLES R. SCHWAB* Chairman and Trustee Chairman, Co-Chief Executive Officer and
July,29, 1937 Director, The Charles Schwab Corporation;
Chairman, Chief Executive Officer and
Director, Charles Schwab Holdings, Inc.;
Chairman and Director, Charles Schwab & Co.,
Inc., Charles Schwab Investment Management,
Inc., The Charles Schwab Trust Company and
Schwab Retirement Plan Services, Inc.;
Chairman and Director (current board
positions), and Chairman (officer position)
until December 1995, Mayer & Schweitzer,
Inc. (a securities brokerage subsidiary of
The Charles Schwab Corporation); Director,
The Gap, Inc. (a clothing retailer),
Transamerica Corporation (a financial
services organization), AirTouch
Communications (a telecommunications
company) and Siebel Systems (a software
company).
STEVEN L. SCHEID* President and Trustee Vice Chairman and Executive Vice President,
The June 28, 1953 Charles Schwab
Corporation; Vice Chairman and Enterprise
President - Financial Products and Services,
Charles Schwab & Co., Inc.; Chief Executive
Officer, Chief Financial Officer and
Director, Charles Schwab Investment
Management, Inc. From 1994 to 1996, Mr.
Scheid was Executive Vice President of
Finance for First Interstate Bancorp and
Principal Financial Officer from 1995 to
1996. Prior to 1994, Mr. Scheid was Chief
Financial Officer, First Interstate Bank of
Texas.
DONALD F. DORWARD Trustee Chief Executive Officer, Dorward &
Associates. From 1996 to 1999, Mr. Dorward
was Executive Vice President and Managing
Director, Grey Advertising. From 1990 to
1996, Mr. Dorward was President and Chief
Executive Officer, Dorward & Associates
(advertising and marketing/consulting firm).
</TABLE>
-------------
* This trustee is an "interested person" of the trust.
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<PAGE> 26
<TABLE>
<CAPTION>
NAME/DATE POSITION(S) WITH
OF BIRTH THE TRUST PRINCIPAL OCCUPATIONS & AFFILIATIONS
--------- ---------------- ------------------------------------
<S> <C> <C>
ROBERT G. HOLMES Trustee Chairman, Chief Executive Officer and Director,
May 15, 1931 Semloh Financial, Inc. (international financial
services and investment advisory firm).
JEREMIAH H. CHAFKIN Executive Vice Executive Vice President, SchwabFunds(R),
May 5, 1959 President and Chief Charles Schwab & Co., Inc.; President and Chief
Operating Officer Operating Officer, Charles Schwab Investment
Management, Inc. Prior to November 1999, Mr.
Chafkin was Senior Managing Director, Bankers
Trust Company.
DONALD R. STEPHENS Trustee Managing Partner, D.R. Stephens & Company
June 28, 1938 (investments) and Chairman and
Chief Executive Officer of North American
Trust (real estate investment trust).
MICHAEL W. WILSEY Trustee Chairman, Chief Executive Officer and Director,
August 18, 1943 Wilsey Bennett, Inc. (truck and air
transportation, real estate investment,
management, and investments).
TAI-CHIN TUNG Treasurer and Principal Vice President, Treasurer and Controller,
March 7, 1951 Charles Schwab Investment Management, Inc.
From 1994 to 1996, Ms. Tung was Controller
for Robertson Stephens Investment
Management, Inc. From 1993 to 1994, she was
Vice President of Fund Accounting, Capital
Research and Management Co.
STEPHEN B. WARD Senior Vice President Senior Vice President and Chief Investment
April 5, 1955 and Chief Investment Officer, Charles Schwab Investment Management,
Officer Inc.
FRANCES COLE Secretary Senior Vice President, Chief Counsel and
September 9, 1955 Assistant Corporate Secretary, Charles Schwab
Investment Management, Inc.
</TABLE>
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<PAGE> 27
Each of the above-referenced officers and/or trustees also serves in the same
capacity as described for the trust, for The CharlesSchwab Family of Funds,
Schwab Capital Trust and Schwab Annuity Portfolios. The address of each
individual listed above is 101 Montgomery Street, San Francisco, California
94104.
Each fund is overseen by a board of trustees. The board of trustees meets
regularly to review a fund's activities, contractual arrangements and
performance. The board of trustees is responsible for protecting the interests
of a fund's shareholders. The following table provides information concerning
compensation of the trustees.
<TABLE>
<CAPTION>
($) Pension or ($)
Aggregate Retirement Total
Name of Trustee Compensation Benefits Accrued Compensation
from each Fund 1 as Part of Fund from Fund
Expenses Complex 2
Short- Total
Term Bond
Bond Market
-------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Charles R. Schwab 0 0 N/A 0
Steven L. Scheid 0 0 N/A 0
William J. Klipp 3 0 0 N/A 0
Donald F. Dorward $2,139 $2,475 N/A $118,150
Robert G. Holmes $2,139 $2,475 N/A $118,150
Donald R. Stephens $2,139 $2,475 N/A $118,150
Michael W. Wilsey $1,982 $2,295 N/A $109,450
</TABLE>
1 For the fiscal year ended August 31, 1999.
2 Unless otherwise stated, information is for the fund complex, which
included 40 funds as of August 31, 1999.
3 Mr. Klipp departed Charles Schwab and Co., Inc. in 1999 and resigned from
the Board of Trustees effective April 30, 2000.
DEFERRED COMPENSATION PLAN
Trustees who are not "interested persons" of a trust ("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 be if the fees credited to the account had been
invested in the shares of SchwabFunds selected by the trustee. Currently, none
of the independent trustees has elected to participate in this plan.
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES
As of October 20, 1999, the officers and trustees of Schwab Total Bond Market
Index Fund, as a group owned of record or beneficially less than 1% of the
outstanding voting securities of the fund.
As of October 20, 1999, the officers and trustees of Schwab Short-Term Bond
Market Index Fund owned of record or beneficially less than 1% of the
outstanding voting securities of the fund, excluding Charles R. Schwab as
reported below.
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<PAGE> 28
As of October 15, 1999, Charles R. Schwab, 101 Montgomery Street, San Francisco
CA 94119 directly or beneficially owned, 10.8% of shares of the Schwab
Short-Term Bond Market Index Fund. As of the same date, MarketTrack Growth II
Portfolio, MarketTrack Growth Portfolio, Market Track Balanced Portfolio, and
Market Track Conservative Portfolio in the aggregate, directly or beneficially
owned 57.9% of the shares of Schwab Total Bond Market Index Fund.
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 Investment Advisory and Administration Agreements
(Advisory Agreements) between it and the trust. Charles Schwab & Co., Inc.
(Schwab) is an affiliate of the investment adviser and is the trust's
distributor, shareholder services agent and transfer agent. Charles R. Schwab is
the founder, Chairman, Co-Chief Executive Officer and Director of The Charles
Schwab Corporation. As a result of his ownership of and interests in The Charles
Schwab Corporation, Mr. Schwab may be deemed to be a controlling person of the
investment adviser and Schwab.
For its advisory and administrative services to each fund, the investment
adviser is entitled to receive a graduated annual fee payable monthly based on
each fund's average daily net assets as described below.
First $500 million - 0.30%
More than $500 million - 0.22%
Prior to November 15, 1999 for its advisory and administrative services for each
fund, the investment adviser was entitled to receive an annual fee, payable
monthly from each fund of 0.41% of each fund's daily net assets.
For the fiscal years ended August 31, 1997, 1998 and 1999, the investment
advisory fees incurred by the Schwab Short -Term Bond Market Index Fund were
$295,000 (fees were reduced by $234,000), $25,000 (fees were reduced by
$561,000) and $0 (fees were reduced by $760,000), respectively.
For the fiscal years ended August 31, 1997, 1998 and 1999, the investment
advisory fees incurred by the Schwab Total Bond Market Index Fund, were $0 (fees
were reduced by $89,000), $0 (fees were reduced by $580,000) and $76,000 (fees
were reduced by $1,498,000), respectively.
The investment adviser and Schwab have voluntarily guaranteed that, through at
least October 31, 2000, total operating expenses (excluding interest, taxes and
certain non-routine expenses) of the Schwab Short-Term Bond Market Index Fund
and Schwab Total Bond Market Index Fund will not exceed 0.35%, of each fund's
average daily net assets.
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
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<PAGE> 29
shareholders. Schwab pays such costs when the described materials are used in
connection with the offering of shares to prospective investors and for
supplementary 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
fund. Schwab maintains the office space, equipment and personnel necessary to
provide these services. Schwab also distributes and markets SchwabFunds and
provides other services. At its own expense, Schwab may engage third party
entities, as appropriate, to perform some or all of these services.
For the services performed as transfer agent under the contract with a fund,
Schwab is entitled to receive an annual fee, payable monthly from each fund, in
the amount of 0.05% of a fund's average daily net assets. For the services
performed as shareholder services agent under its contract with a fund, Schwab
is entitled to receive an annual fee, payable monthly from the funds, in the
amount of 0.20% of the average daily net assets of each fund.
CUSTODIAN AND FUND ACCOUNTANT
PFPC Trust Company, 400 Bellevue Parkway, Wilmington DE 19809, serves as
custodian for the funds and PFPC, Inc., located at the same address, 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 all books and records
related to each fund's transactions.
INDEPENDENT ACCOUNTANT
The funds' independent accountant, PricewaterhouseCoopers LLP, audit and report
on the annual financial statements of each series of the trust and review
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, 1999, will be included in the fund's annual report that
is supplied with the SAI.
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<PAGE> 30
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.
The portfolio turnover rates for the Schwab Total Bond Market Index Fund for the
fiscal years ended August 31, 1998 and 1999 were 285% and 174%, respectively.
The portfolio turnover rates for the Schwab Short-Term Bond Index Fund for the
fiscal years ended August 31, 1998 and 1999 were 128% and 195%, respectively.
PORTFOLIO TRANSACTIONS
The funds paid no brokerage commissions in the last three fiscal years.
In effecting securities transactions for the fund, the investment adviser seeks
to obtain best execution. Subject to the supervision of the board of trustees,
the investment adviser will select brokers and dealers for the fund on the basis
of a number of factors, including, for example, price paid for securities,
clearance, settlement, reputation, financial strength and stability, efficiency
of execution and error resolution, block trading and block positioning
capabilities, willingness to execute related or unrelated difficult transactions
in the future, and order of call.
When the execution capability and price offered by two or more broker-dealers
are comparable, the investment adviser may, in its discretion, in agency
transactions (and not principal transactions) utilize the services of
broker-dealers that provide it with investment information and other research
resources. Such resources also may be used by the investment adviser when
providing advisory services to its clients.
The fund expects that purchases and sales of portfolio securities will usually
be principal transactions. Securities will normally be purchased directly from
the issuer or from an underwriter or market maker for the securities. Purchases
from underwriters will include a commission or concession paid by the issuer to
the underwriter, and purchases from dealers serving as market makers will
include the spread between the bid and asked prices.
The investment decisions for the fund are reached independently from those for
other accounts managed by the investment adviser. Such other accounts also may
make investments in instruments or securities at the same time as the fund. When
two or more accounts managed by the investment adviser have funds available for
investment in similar instruments, available instruments are allocated as to
amount in a manner considered equitable to each account. In some cases, this
procedure may affect the size or price of the position obtainable for the fund.
However, it is the opinion of the board of trustees that the benefits conferred
by the investment adviser outweigh any disadvantages that may arise from
exposure to simultaneous transactions.
In an attempt to obtain best execution for the fund, the investment adviser may
place orders directly with market makers or with third market brokers, Instinet
or brokers on an agency basis. Placing orders with third market brokers or
through Instinet may enable the fund to trade directly with other
30
<PAGE> 31
institutional holders on a net basis. At times, this may allow the fund to trade
larger blocks than would be possible trading through a single market maker.
DESCRIPTION OF THE TRUST
Each fund is a series of Schwab Investments. Schwab Investments was organized
under Massachusetts' law on October 26, 1990.
The Declaration of Trust provides that shares may be automatically redeemed if
held by a shareholder in an amount less than the minimum required by a fund or
share class. Each fund's initial and subsequent minimum investment and balance
requirements are set forth in the prospectus. These minimums may be waived for
certain investors, including trustees, officers and employees of Schwab, or
changed without prior notice.
Each fund may hold special meetings, which may cause the funds to incur
non-routine expenses. These meetings may be called for purposes such as electing
trustees, changing fundamental policies and amending management contracts.
Shareholders are entitled to one vote for each share owned and may vote by proxy
or in person. Proxy materials will be mailed to shareholders prior to any
meetings, and will include a voting card and information explaining the matters
to be voted upon.
The bylaws of the trust provides that a majority of shares entitled to vote
shall be a quorum for the transaction of business at a shareholders' meeting,
except that where any provision of law, or of the Declaration of Trust or of the
bylaws permits or requires that (1) holders of any series shall vote as a
series, then a majority of the aggregate number of shares of that series
entitled to vote shall be necessary to constitute a quorum for the transaction
of business by that series, or (2) holders of any class shall vote as a class,
then a majority of the aggregate number of shares of that class entitled to vote
shall be necessary to constitute a quorum for the transaction of business by
that class. A majority of the outstanding voting shares of the fund means the
affirmative vote of the lesser of: (a) 67% or more of the voting shares
represented at the meeting, if more than 50% of the outstanding voting shares of
a fund are represented at the meeting or (b) more than 50% of the outstanding
voting shares of a fund. 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.
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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 REPORTS AND PRICING OF SHARES
PURCHASING AND REDEEMING SHARES OF THE FUNDS
As long as a fund or Schwab follow reasonable procedures to confirm that your
telephone or internet order is genuine, they will not be liable for any losses
an 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.
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
Securities traded on stock exchanges are valued at the last-quoted sales price
on the exchange on which such securities are primarily traded, 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 sales price that day, or if no
sales that day, at the mean between the bid and ask prices. Securities for which
market quotations or closing values are not readily available (including
restricted securities that are subject to limitations on their sale and illiquid
securities) are valued at fair value as determined in good faith pursuant to
guidelines and procedures adopted by the board of trustees. These procedures
require that securities be valued on the basis of prices provided by approved
pricing services, except when a price appears manifestly incorrect or events
occurring between the time a price is furnished by a service and the time a fund
calculates its share price materially affect the furnished price. The board of
trustees regularly reviews fair values assigned to portfolio
securities under these circumstances and also when no prices from approved
pricing services are available.
TAXATION
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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 on its net investment income and 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 a fund's 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 advisers 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. 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. 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.
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Each fund will be required in certain cases to withhold and remit to the U.S.
Treasury 31% 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; or (3) fails
to provide a certified statement that he or she is not subject to "backup
withholding." 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.
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.
<TABLE>
<CAPTION>
Average Annual Total Average Annual Total Average Annual Total
Return for 1 year Return for 5 years Return from
ended August 31, 1999 ended August 31, 1999 commencement of
operations to August
31, 1999*
<S> <C> <C> <C>
Schwab Short-Term Bond Fund 2.66% 5.63% 5.58%
Schwab Total Bond Market 0.14% 7.36% 5.99%
Index Fund
</TABLE>
* November 5, 1991 for Schwab Short-Term Bond Market Index Fund and March
5, 1993 for the Schwab Total Bond Market Index Fund.
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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.
<TABLE>
<CAPTION>
Fund Cumulative Total Return as of August 31, 1999*
<S> <C>
Schwab Short-Term Bond Index Fund 52.89%
Schwab Total Bond Market Index Fund 45.94%
</TABLE>
* November 5, 1991 for Schwab Short-Term Bond Market Index Fund and March
5, 1993 for the Schwab Total Bond Market Index Fund.
A 30-day yield is calculated by dividing the net investment income per share
earned during a 30-day period by a fund's share price on the last day of the
period.
<TABLE>
<CAPTION>
Fund 30-day period ended August 31, 1999
<S> <C>
Schwab Short-Term Bond Index Fund 5.71%
Schwab Total Bond Market Index Fund 6.25%
</TABLE>
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 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.
COMPARATIVE INDEX PERFORMANCE
Each fund's performance may be compared to various unmanaged bond indexes in
addition to the Lehman Brothers Short (1-5) Government/Corporate Index and the
unmanaged Lehman Brothers Aggregate Bond Index, including but not limited to,
the Salomon Brothers High Grade Index, the Shearson Lehman Government/Corporate
Bond Index, the Merrill Lynch Government/Corporate Bond Master Index and to
Lipper Analytical Services, 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 30, 1998. This historical information is not
indicative of any future trend of the funds or the particular market sectors
that the Indexes represent.
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<TABLE>
<CAPTION>
DATE AGGREGATE BOND INDEX GOVERNMENT/CORPORATE INDEX
<S> <C> <C>
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
</TABLE>
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APPENDIX - RATINGS OF INVESTMENT SECURITIES
From time to time, a fund may report the percentage of its assets that fall 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.
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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.
DUFF & PHELPS CREDIT RATING CO.
AAA Highest credit quality. The risk factors are negligible, being only
slightly more than for risk-free U.S. Treasury debt.
AA+ HIGH CREDIT QUALITY. PROTECTION FACTORS ARE STRONG. RISK IS MODEST BUT
MAY VARY SLIGHTLY
AA- FROM TIME TO TIME BECAUSE OF ECONOMIC CONDITIONS.
A+ Protection factors are average but adequate. However, risk factors are
more variable and
A- greater in periods of economic stress.
BBB+ Below average protection factors but still considered sufficient for
prudent investment.
BBB- Considerable variability in risk during economic cycles.
BB+ Below investment grade but deemed likely to meet obligations when due.
Present or
BB prospective financial protection factors fluctuate according to
industry
BB- conditions or company fortunes. Overall quality may move up or down
frequently within this category.
B+ Below investment grade and possessing risk that obligations will not be
met when due.
B Financial protection factors will fluctuate widely according to
economic cycles, industry
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B- conditions and/or company fortunes. Potential exists for frequent
changes in the rating within this category or into a higher or lower
rating grade.
FITCH IBCA, 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 'F-1+'.
A Bonds considered to be investment grade and of high credit quality. The
obligor's ability to pay interest and repay principal is considered to
be strong, but may be more vulnerable to adverse changes in economic
conditions and circumstances than bonds with higher ratings.
BBB Bonds considered to be investment grade and of satisfactory credit
quality. The obligor's ability to pay interest and repay principal is
considered to be adequate. Adverse changes in economic conditions and
circumstances, however, are more likely to have adverse impact on these
bonds, and therefore impair timely payment. The likelihood that the
ratings of these bonds will fall below investment grade is higher than
for bonds with higher ratings.
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.
DESCRIPTION OF THOMSON BANKWATCH'S LONG-TERM DEBT RATINGS
INVESTMENT GRADE
AAA The highest category; indicates that the ability to repay principal and
interest on a timely basis is very high.
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AA The second-highest category; indicates a superior ability to repay
principal and interest on a timely basis, with limited incremental risk
compared to issues rated in the highest category.
A The third-highest category; indicates the ability to repay principal
and interest is strong. Issues rated "A" could be more vulnerable to
adverse developments (both internal and external) than obligations with
higher ratings.
BBB The lowest investment-grade category; indicates an acceptable capacity
to repay principal and interest. Issues rated "BBB" are, however, more
vulnerable to adverse developments (both internal and external) than
obligations with higher ratings.
NON-INVESTMENT GRADE
BB While not investment grade, the "BB" rating suggests that the
likelihood of default is considerably less than for lower-rated issues.
However, there are significant uncertainties that could affect the
ability to adequately service debt obligations.
B Issues rated "B" show a higher degree of uncertainty and therefore
greater likelihood of default than higher-rated issues. Adverse
developments could well negatively affect the payment of interest and
principal on a timely basis.
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 IBCA, 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.
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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.
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.
DUFF & PHELPS CREDIT RATING CO.
D-1 is the highest commercial paper rating assigned by Duff. Three
gradations exist within this rating category: A D-1+ rating indicates the
highest certainty of timely payment (issuer short-term liquidity is found to be
outstanding and safety is deemed to be just below that of risk-free short-term
U.S. Treasury obligations), a D-1 rating signifies a very high certainty of
timely payment (issuer liquidity is determined to be excellent and risk factors
are considered minor) and a D-1- rating denotes high certainty of timely payment
(issuer liquidity factors are strong and risk is very small). A D-2 rating
indicates a good certainty of timely payment. Liquidity factors and company
fundamentals are sound and risk factors are small.
FITCH IBCA, INC.
F-1+ is the highest category, and indicates the strongest degree of
assurance for timely payment. Issues rated F-1 reflect an assurance of timely
payment only slightly less than issues rated F-1+. Issues assigned an F-2 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.
COMMERCIAL PAPER, SHORT-TERM OBLIGATIONS
AND DEPOSIT OBLIGATIONS ISSUED BY BANKS
THOMSON BANKWATCH (TBW)
TBW-1 is the highest category and indicates the degree of safety
regarding timely repayment of principal and interest is very high. TBW-2 is the
second highest category and while the degree of safety regarding timely
repayment of principal and interest is strong, the relative degree of safety is
not as high as for issues rated "TBW-1."
41
