When reporting bond maturity dates to the public and Securities and Exchange Commission for investments held in the Schwab YieldPlus Fund, the fund managers chose a different method than their peers.
Although Schwab disclosed this peculiar manner for reporting maturity dates for certain types of bonds in the Schwab YieldPlus Fund’s portfolio, Schwab’s diversion from the normal manner in which bond funds report maturity dates understated maturity dates for some of the individual investments held in the Schwab YieldPlus Fund’s portfolio by many years in some cases.
Take for example the Schwab YieldPlus Fund’s substantial portfolio holding of an asset-backed obligation called the SLM Student Loan Trust Series 2005-5, Class A2: Schwab reported on its May 31, 2007 Form NQ filing with the SEC that this investment had a “maturity date” of Oct. 25, 2007. However, this contradicts SEC filings by the SLM Student Loan Trusts and understates the actual legal stated maturity date for this investment by 14 years.
SLM Student Loan Trusts prospectus supplements filed with the SEC disclose that the actual maturity date of the SLM Student Loan Trust Series 2005-5, Class A2 is Oct. 25, 2021.
Schwab Investments’ practice has been to report the next interest rate reset date rather than the actual legal stated final maturity date of the security for floating and variable rate obligations. Schwab Investments discloses this practice on the first page of the descriptions of the individual securities held in each of its bond fund portfolios.
This practice lured investors into purchasing a much riskier bond mutual fund than advertised. Calculations by the Shine Vernon legal team show that Schwab’s YieldPlus Fund was not an “ultra short-term” bond fund.
Understanding Bond Maturities
Bond investors generally understand that a AAA rated corporate or municipal bond that will mature in six months is a much safer investment than a AAA rated bond that will mature in five years, both in terms of default risk and in terms of interest rate risk/price sensitivity. With respect to default risk, this understanding is based upon the much lower probability that the issuer of a six month bond might default on its obligation to pay investors the par value of the bond prior to the maturity date.
As the term to maturity of bonds lengthen, investors typically demand higher rates of return as compensation for the increased probability or risk that the issuer of the bonds might encounter financial difficulties prior to the bond’s maturity date and be unable to pay back the principal owed to bondholders.
With respect to interest rate risk, shorter term bonds have lower interest rate risk than longer term bonds because short-term bondholders receive their bond principal back earlier than long-term bondholders. Short-term bondholders can then reinvest the par value of their recently matured bonds into new or outstanding bonds that pay the higher prevailing market interest rates.
The Schwab YieldPlus Fund in its initial public offering (IPO) prospectus dated July 21, 1999 represented that the fund would be investing in investment grade (high and certain medium quality) bonds. Investment grade bonds have Standard & Poor’s ratings that include AAA (highest quality/safest), AA, A and BBB. The Schwab YieldPlus Fund IPO prospectus’ emphasis on safety is reflected in the following excerpt:
. . . To help maintain a very high degree of share price stability and preserve investors’ capital, the fund seeks to keep the average effective maturity of its overall portfolio at one year or less. . . . (Emphasis and underlining supplied.) Schwab YieldPlus Fund Prospectus Dated July 21, 1999 at p. 4.
Schwab Investments, the issuer of the Schwab YieldPlus Fund, revises and disseminates an updated prospectus for the Schwab YieldPlus Fund at least annually. The Schwab YieldPlus Fund prospectus dated Nov. 15, 2000 subtly changed the above quoted language as follows:
. . . To help maintain a very high degree of share price stability and preserve investors’ capital, the fund seeks to keep the average effective duration of its overall portfolio at one year or less. . . . (Emphasis supplied.) Schwab YieldPlus Fund Prospectus Dated Nov. 15, 2000 at p. 4.
Duration is another measure of interest rate risk, that is, how sensitive a bond’s market value is to a 1 percent change in market interest rates. For example, if a bond has a duration of 2.5, and interest rates change by 1 percent, this bond could be expected to decrease in value by 2.5 percent in the case of an interest rate increase or increase in value by the same amount in the event of an interest rate decrease.
As will be discussed below, a floating or variable rate bond which periodically adjusts its coupon interest payment to reflect current prevailing market interest rates can simultaneously have a low duration (low interest rate volatility) and a long-term maturity.
Calling Schwab YieldPlus an “Ultra Short-term Bond Fund”
Beginning in November 2004, Schwab YieldPlus prospectuses represented that the fund was both an “ultra short-term bond fund” and a fund that had “an average duration of one year or less.” Simple calculations based upon Schwab Investments’ descriptions contained in its quarterly, semiannual and annual reports of the individual bonds held by the Schwab YieldPlus Fund indicate that the fund was not really an ultra short-term bond fund, as represented by Schwab Investments and Charles Schwab, but an intermediate to long-term bond fund.
For example, the Schwab Investments Annual Report for the period ending August 31, 2007 reported to the SEC and the public that the weighted average maturity of the bond fund’s portfolio was six months as of that date. The Shine-Vernon legal team’s experts have analyzed the Schwab YieldPlus Fund portfolio holdings listed in the public SEC Annual Report filed by Schwab Investments and estimate that the fund’s weighted average maturity was more than six years as of the same date.
This “ultra short-term bond fund” misrepresentation regarding the weighted average maturity of the fund’s bond portfolio combined with additional specific misrepresentations pertaining to the actual weighted average maturity of the fund at various points in time (See weighted average maturity calculations for Feb. 28, 2007 and Aug. 31, 2007 below.) accomplished the following for Schwab’s benefit. The misrepresentations:
■ lured investors into purchasing a product that was much riskier than advertised and;
■ encouraged existing Schwab YieldPlus Fund shareholders in 2007 and 2008 to hold their shares based upon their understanding that the net asset value price per share of the fund would imminently recover when the highly rated bonds in the portfolio (AA or high credit quality) matured at par value within the next six months.
Schwab Investments’ Reporting Method Obfuscates Investors’ Accurate Evaluations
Schwab Investments’ manner of reporting the maturity dates of the floating and variable rate securities in the Schwab YieldPlus Fund portfolio prevented investors from making an accurate evaluation of the weighted average maturity of the fund’s portfolio .
Schwab Investments began filing semiannual and annual reports for the Schwab YieldPlus Fund in 2000. From the filing of its initial semiannual report for the period ending Feb. 29, 2000 through the present, Schwab Investments’ practice has been to report the next interest rate reset date rather than the actual legal stated final maturity date of the security for floating and variable rate obligations. Schwab Investments discloses this practice on the first page of the descriptions of the individual securities held in each of its bond fund portfolios.
However, this manner of reporting gives the term to maturity of the individual security positions and the weighted average term to maturity of the portfolio as a whole the appearance of being much shorter than they actually are. Schwab Investments’ practice of not reporting stated final maturity dates for floating and variable rate securities also makes it impossible to calculate a true weighted average maturity for the portfolio . Schwab Investments’ practice was contrary to the manner in which other ultrashort bond funds reported the maturity dates of the floating and variable rate bonds in their portfolios (i.e., actual maturity dates were reported rather than interest rate reset dates).
The following example illustrates the disparity between the actual maturity dates of the variable rate securities owned by the Schwab YieldPlus Fund and the manner in which Schwab Investments reported the maturity dates to the public. Schwab Investments reported in a Form NQ that, as of May 31, 2007, the Schwab YieldPlus Fund held a substantial position in the following asset-backed obligation issued by the SLM Student Loan Trust:
Schwab YieldPlus Fund
Portfolio Holdings (Unaudited) continued
Security Face Amount Value
Rate, Maturity Date ($ x 1,000) ($ x 1,000)
SLM Student Loan Trust
Series 2005-5 Class A2
5.35%, 07/25/07 (a)(b)(d) 157,250 156,677
Although the interest rate reset date of July 25, 2007 (65 days or less than 3 months) is listed as the maturity date for this bond in the Schwab Investments Form NQ, the SLM Student Loan Trust prospectus supplement filed with the SEC discloses that the actual maturity date of the SLM Student Loan Trust Series 2005-5, Class A2 asset-backed obligation is October 25, 2021.
This maturity date is fourteen years more than the interest rate reset date listed as the maturity date by Schwab Investments in the Form NQ.
The Shine-Vernon legal team’s expert witnesses have calculated the weighted average term to maturity of the Schwab YieldPlus Fund portfolio for the periods ending Feb. 28, 2007 (Semiannual Report), May 31, 2007 (Form NQ) and Aug. 31, 2007 (Annual Report). We have assumed that, for the purposes of making these calculations, the interest rate reset dates for the floating and variable rate obligations are the actual final maturity dates (i.e., Schwab Investments’ custom and practice). The Schwab Investments calculations and the Shine-Vernon team calculations of Weighted Average Maturity are as follows:
Schwab Inv. Reported Shine-Vernon Team Calculation
Weighted Aver. Mat. Weighted Aver. Mat.
Feb. 28, 2007 2.9 years 6.96 years
May 31, 2007 Not Reported 6.46 years
Aug. 31, 2007 0.5 years 6.17 years
The Shine-Vernon Team experts’ calculations of the Schwab YieldPlus Fund’s weighted average maturities, which most likely significantly understate the true weighted average maturities of the fund, indicate that the Schwab YieldPlus Fund was actually an intermediate and possibly a long-term bond fund with respect to term of maturity. The Schwab YieldPlus Fund may have been an ultrashort duration bond fund only in terms of interest rate volatility, due to the portfolio’s high proportional asset concentration in floating and variable rate securities.
The Shine-Vernon Team’s review of annual, semiannual and quarterly reports filed during 2007 by more than ten other ultrashort bond funds reveals that, unlike Schwab Investments, these funds, without exception, report the actual final term to maturity dates of all floating or variable rate securities, rather than the interest rate reset dates.
As described above, the Schwab YieldPlus Fund’s investment strategies contained in the fund’s prospectuses indicate that the fund changed the manner in which it would minimize price fluctuations associated with interest rate risk from maintaining a portfolio with an ultra short-term maturity to maintaining a portfolio with an ultrashort duration. This subtle language change points to a significant shift in the investment strategies of Schwab YieldPlus Fund portfolio managers to increase the fund’s concentration in longer-term floating and variable rate securities that had low effective durations due to the periodic interest rate reset feature of the securities (i.e., low interest rate volatility/risk).
These floating or variable rate securities had long-term final maturity dates, which means that they would need to be held much longer than ultra short-term securities in order for the Schwab YieldPlus Fund and its shareholders to receive the returns of the face or par value of the securities.
These longer-term floating and variable rate securities, which Schwab Investments represented as being of high credit quality (AA or low default risk), would mature at face value assuming that there were no defaults by the issuers. Although this new strategy may have been effective for limiting interest rate risk, it was ill-suited to limiting the fund’s liquidity risk. For example, this strategy left the fund without sufficient cash equivalents available to satisfy shareholder redemptions.
Indeed, it had disastrous effects in 2007 and 2008 when the fund’s portfolio managers were forced to sell these longer term and illiquid securities at distressed prices prior to their maturity dates in order to raise cash to meet ever-escalating cumulative shareholder redemptions.
Nonetheless, in the face of this situation, Schwab YieldPlus Fund lead portfolio manager Kimon Daifotis and Charles Schwab in their communications to Schwab YieldPlus Fund shareholders repeatedly represented during the last four months of 2007 and in early 2008 that substantial portions of the Schwab YieldPlus Fund’s losses were “unrealized.” These representations led shareholders to believe that:
■ The fund would recover all or a significant portion of these unrealized losses as long as the fund was able to hold the bonds that it currently owned for six months or a year; and
■ That the net asset value price per share of the Schwab YieldPlus Fund would recover within the next six months to a year as the bonds in the portfolio matured at par value.
Such statements were false and misleading. The actual weighted average maturity of the fund was far in excess of the six months that Schwab Investments reported to the SEC and to the public in the fund’s Annual Report for the period ending Aug. 31, 2007. The deception of shareholders through these sorts of communications is even more egregious given that Charles Schwab and Mr. Daifotis contemporaneously knew that the fund was experiencing steady and substantial net redemptions, which made it almost certain that the fund would not be able to hold a significant portion of the long-term bonds in the portfolio until they matured.
For more information, please contact attorney Chris Vernon of Vernon Healy by email at cvernon@vernonhealy.com or by phone at (239) 649-5390.
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