Four decades later, that revolutionary spirit continues to animate the enterprise. Vanguard remains on a mission to give investors the best chance of investment success.

As we mark our 40th anniversary, we thank you for entrusting your assets to Vanguard and giving us the opportunity to help you reach your financial goals in the decades to come.

Despite the U.S. bond market’s weak start and some bumps along the way, all of the Vanguard Sector Bond Index Funds posted positive returns for the six months ended February 28, 2015. As in the 2014 fiscal year, the two long-term funds were the standouts. But this time, long corporates took a backseat to long governments, which benefited from especially strong demand for longer-term U.S. Treasuries.

Vanguard Long-Term Government Bond Index Fund returned 9.19% for the half year, nearly 7 percentage points ahead of the overall bond market and ahead by 3 percentage points of even the broad U.S. stock market. (The returns and yields cited in this letter are for the funds’ ETF shares, based on net asset value.) Vanguard Long-Term Corporate Bond Index Fund returned 4.16%. Higher bond prices accounted for almost 85% of the long-term government fund’s return and almost half of the long-term corporate fund’s return. (See the capital returns in the accompanying tables.)

The two intermediate-term funds and the mortgage-backed securities fund returned about 2%; both short-term funds returned less than 1%. Short- and intermediate-term corporate bonds modestly outpaced their government counterparts—unlike the pattern at the long end.

Continuing last year’s trend, shorter-term bond yields rose modestly, consistent with the expectation that the Federal Reserve will begin to raise short-term rates in 2015. For example, the short-term corporate fund’s yield rose from 1.40% at the end of August to 1.62% at the end of February, which held back the fund’s return. (Bond yields and prices move in opposite directions.) The mortgage-backed securities fund’s yield also inched up, by 15 basis points. (A basis point is one-hundredth of a percentage point.)

Meanwhile, the yields of the intermediate-and long-term funds declined again as prospects for the global economy grew more clouded, any upswing in inflation appeared more distant, and bonds offered a safe harbor as geopolitical tensions flared.

Bonds notched positive results despite early and late retreats
The broad U.S. taxable bond market returned 2.25%. When the stock market turned volatile, investors favored the relative safety offered by bonds, which also benefited from various global stimulus

Municipal bonds, which returned 2.21%, lost some steam toward the end of the period amid increased bond issuance and the prospect of higher interest rates.

International bond markets (as measured by the Barclays Global Aggregate Index ex USD) returned –9.54% for dollar-based investors, weighed down by the weakness of foreign currencies relative to the dollar. International bonds that were hedged to eliminate the effect of currency exchange rates produced positive returns.

A surge in February powered U.S. stocks
U.S. stocks performed solidly but unevenly over the six months. Despite declines in two of those months and flat returns in another, the broad U.S. stock market ended the period up about 6%.

The overall return was powered by a robust advance in February, when the broad market recorded its largest monthly gain since October 2011. Investors were cheered by stabilization in oil prices and guidance from the Federal Reserve that it wouldn’t raise interest rates prematurely.

After some ups and downs, international stocks returned about –3% in dollar terms. The dollar’s strength against many foreign currencies, along with various geopolitical issues, restrained results. Stocks in emerging and developed markets backtracked, with emerging markets faring the worst. In local currency terms, though, international stocks rose.

Even amid higher volatility, bonds delivered strong returns
The U.S. bond market generally continued to confound expectations. As the U.S. economy grew and the Fed ended its bond-buying program in October, interest rates were expected to rise. Among the key questions on the minds of investors and analysts were “When?” and “How much?”

Bond market returns in January and February differed notably. The broad U.S. market returned more than 2% in January then declined about 1% in February. Volatility was more pronounced in the long-term government fund, which had an exceptional return of nearly 9% in January amid uncertainty about Greece’s ability to meet its Eurozone debt bailout obligations.

But in February, signs of a brighter outlook for European growth and a last-minute agreement on Greece made investors less keen to duck for cover. And as debate grew livelier over when the Fed might raise rates, long-term government bonds gave back much of January’s gains.

Still, after the dust settled, the six-month returns of corporate and government bonds were similar. Corporate bonds, represented by the Barclays U.S. Credit Index, returned 2.14%, and the Barclays U.S. Government Index returned 2.32%. Agency mortgage-backed securities performed in line with the broad corporate market; because of their slightly lower credit quality, they generally continued to provide a small yield premium over comparable-maturity Treasuries.

A combination of factors supported bond demand and prices during the six months. Investors seeking a haven from geopolitical conflicts, such as that between Russia and Ukraine, and from stock-market volatility turned to bonds in general. They favored longer-term Treasuries in particular, not only for the added allure of their higher yields but also because short-term interest rates were expected to keep inching up (hurting prices of shorter-term bonds). Greece’s debt predicament—coupled with concerns about deflation and slower economic growth in Europe, China, Japan, and elsewhere—added to Treasuries’ appeal.

Many foreign investors flocked to higher-yielding U.S. bonds as the yields on short- to intermediate-term sovereign bonds of several European countries turned negative. The relative strength of the U.S. dollar also contributed to strong foreign demand. An investor whose home currency is the euro, for example, can earn a currency return from a U.S. bond if the euro continues to weaken.

All seven funds outpaced the average returns of their peers. The widest margin belonged to the two long-term funds. Their longer durations compared with peer groups spanning a wider range of

Both ETFs and mutual funds offer opportunities for long-term success
The popularity of exchange-traded funds (ETFs), most of which seek to track an index, has surged over the past decade. We see this as an indication that our message is taking hold: Broad diversification and low costs are keys to long-term success, and indexing is a great way to implement strategies based on those tenets.

As you probably know, ETFs combine the investment characteristics of mutual funds with the trading characteristics of stocks. Like stocks, ETF prices change throughout the day. In contrast, traditional open-end mutual funds are priced once a day, shortly after the market’s close.

Some say that ETFs are more of a trading tool than an investment tool. We don’t think that this has to be the case. In fact, we’re seeing much greater use of ETFs as part of long-term plans. Certainly, ETFs are easy to trade. But they are also easy to hold. And, unlike with traditional mutual funds, the investor doing the trading is the one who pays the transaction costs—not the other fund shareholders.

Vanguard ETFs are simply another share class of our traditional mutual funds. Clients select the share class that best meets their needs. The portfolios are identical. Vanguard research has shown that ETFs and mutual funds perform essentially the same investment function, and that investors can use both to create a low-cost, well-diversified portfolio of stocks and bonds. You can read more in

Buying on the FACTs: Investors’ Choices Between ETFs and Mutual Funds, at vanguard.com/research.

As always, thank you for investing with Vanguard.

Sincerely,

A. The following significant accounting policies conform to generally accepted accounting principles for U.S. investment companies. The fund consistently follows such policies in preparing its financial statements.

1. Security Valuation: Securities are valued as of the close of trading on the New York Stock Exchange (generally 4 p.m., Eastern time) on the valuation date. Bonds, and temporary cash investments acquired over 60 days to maturity, are valued using the latest bid prices or using valuations based on a matrix system (which considers such factors as security prices, yields, maturities, and ratings), both as furnished by independent pricing services. Investments in Vanguard Market Liquidity Fund are valued at that fund’s net asset value. Other temporary cash investments are valued at amortized cost, which approximates market value. Securities for which market quotations are not readily available, or whose values have been affected by events occurring before the fund’s pricing time but after the close of the securities’ primary markets, are valued by methods deemed by the board of trustees to represent fair value.

2. Federal Income Taxes: The fund intends to continue to qualify as a regulated investment company and distribute all of its taxable income. Management has analyzed the fund’s tax positions taken for all open federal income tax years (August 31, 2011–2014), and for the period ended February 28, 2015, and has concluded that no provision for federal income tax is required in the fund’s financial statements.

3. Distributions: Distributions to shareholders are recorded on the ex-dividend date.

4. Credit Facility: The fund and certain other funds managed by The Vanguard Group participate in a $2.89 billion committed credit facility provided by a syndicate of lenders pursuant to a credit agreement that may be renewed annually; each fund is individually liable for its borrowings, if any, under the credit facility. Borrowings may be utilized for temporary and emergency purposes, and are subject to the fund’s regulatory and contractual borrowing restrictions. The participating funds are charged administrative fees and an annual commitment fee of 0.06% of the undrawn amount of the facility; these fees are allocated to the funds based on a method approved by the fund’s board of trustees and included in Management and Administrative expenses on the fund’s Statement of Operations. Any borrowings under this facility bear interest at a rate equal to the higher of the federal funds rate or LIBOR reference rate plus an agreed-upon spread.

The fund had no borrowings outstanding at February 28, 2015, or at any time during the period then ended.

5. Other: Interest income includes income distributions received from Vanguard Market Liquidity Fund and is accrued daily. Premiums and discounts on debt securities purchased are amortized and accreted, respectively, to interest income over the lives of the respective securities. Security transactions are accounted for on the date securities are bought or sold. Costs used to determine realized gains (losses) on the sale of investment securities are those of the specific securities sold.

Each class of shares has equal rights as to assets and earnings, except that each class separately bears certain class-specific expenses related to maintenance of shareholder accounts (included in Management and Administrative expenses) and shareholder reporting. Marketing and distribution

B. The Vanguard Group furnishes at cost investment advisory, corporate management, administrative, marketing, and distribution services. The costs of such services are allocated to the fund based on methods approved by the board of trustees. The fund has committed to invest up to 0.40% of its net assets in Vanguard. At February 28, 2015, the fund had contributed capital of $75,000 to Vanguard (included in Other Assets), representing 0.01% of the fund’s net assets and 0.03% of Vanguard’s capitalization. The fund’s trustees and officers are also directors and officers of Vanguard.

C. Various inputs may be used to determine the value of the fund’s investments. These inputs are summarized in three broad levels for financial statement purposes. The inputs or methodologies used to value securities are not necessarily an indication of the risk associated with investing in those securities.

Level 1—Quoted prices in active markets for identical securities.
Level 2—Other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds, credit risk, etc.).
Level 3—Significant unobservable inputs (including the fund’s own assumptions used to determine the fair value of investments).

During the six months ended February 28, 2015, the fund realized $341,000 of net capital gains resulting from in-kind redemptions—in which shareholders exchanged fund shares for securities held by the fund rather than for cash. Because such gains are not taxable to the fund, and are not distributed to shareholders, they have been reclassified from accumulated net realized gains to paid-in capital.

At February 28, 2015, the cost of investment securities for tax purposes was $773,849,000. Net unrealized appreciation of investment securities for tax purposes was $1,007,000, consisting of unrealized gains of $1,171,000 on securities that had risen in value since their purchase and $164,000 in unrealized losses on securities that had fallen in value since their purchase.

F. Capital share transactions for each class of shares were:

A. The following significant accounting policies conform to generally accepted accounting principles for U.S. investment companies. The fund consistently follows such policies in preparing its financial statements.

1. Security Valuation: Securities are valued as of the close of trading on the New York Stock Exchange (generally 4 p.m., Eastern time) on the valuation date. Bonds, and temporary cash investments acquired over 60 days to maturity, are valued using the latest bid prices or using valuations based on a matrix system (which considers such factors as security prices, yields, maturities, and ratings), both as furnished by independent pricing services. Investments in Vanguard Market Liquidity Fund are valued at that fund’s net asset value. Other temporary cash investments are valued at amortized cost, which approximates market value. Securities for which market quotations are not readily available, or whose values have been affected by events occurring before the fund’s pricing time but after the close of the securities’ primary markets, are valued by methods deemed by the board of trustees to represent fair value.

2. Federal Income Taxes: The fund intends to continue to qualify as a regulated investment company and distribute all of its taxable income. Management has analyzed the fund’s tax positions taken for all open federal income tax years (August 31, 2011–2014), and for the period ended February 28, 2015, and has concluded that no provision for federal income tax is required in the fund’s financial statements.

3. Distributions: Distributions to shareholders are recorded on the ex-dividend date.

4. Credit Facility: The fund and certain other funds managed by The Vanguard Group participate in a $2.89 billion committed credit facility provided by a syndicate of lenders pursuant to a credit agreement that may be renewed annually; each fund is individually liable for its borrowings, if any, under the credit facility. Borrowings may be utilized for temporary and emergency purposes, and are subject to the fund’s regulatory and contractual borrowing restrictions. The participating funds are charged administrative fees and an annual commitment fee of 0.06% of the undrawn amount of the facility; these fees are allocated to the funds based on a method approved by the fund’s board of trustees and included in Management and Administrative expenses on the fund’s Statement of Operations. Any borrowings under this facility bear interest at a rate equal to the higher of the federal funds rate or LIBOR reference rate plus an agreed-upon spread.

The fund had no borrowings outstanding at February 28, 2015, or at any time during the period then ended.

5. Other: Interest income includes income distributions received from Vanguard Market Liquidity Fund and is accrued daily. Premiums and discounts on debt securities purchased are amortized and accreted, respectively, to interest income over the lives of the respective securities. Security transactions are accounted for on the date securities are bought or sold. Costs used to determine realized gains (losses) on the sale of investment securities are those of the specific securities sold.

B. The Vanguard Group furnishes at cost investment advisory, corporate management, administrative, marketing, and distribution services. The costs of such services are allocated to the fund based on methods approved by the board of trustees. The fund has committed to invest up to 0.40% of its net assets in Vanguard. At February 28, 2015, the fund had contributed capital of $61,000 to Vanguard (included in Other Assets), representing 0.01% of the fund’s net assets and 0.02% of Vanguard’s capitalization. The fund’s trustees and officers are also directors and officers of Vanguard.

C. Various inputs may be used to determine the value of the fund’s investments. These inputs are summarized in three broad levels for financial statement purposes. The inputs or methodologies used to value securities are not necessarily an indication of the risk associated with investing in those securities.

Level 1—Quoted prices in active markets for identical securities.
Level 2—Other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds, credit risk, etc.).
Level 3—Significant unobservable inputs (including the fund’s own assumptions used to determine the fair value of investments).

The following table summarizes the market value of the fund’s investments as of February 28, 2015, based on the inputs used to value them:

During the six months ended February 28, 2015, the fund realized $94,000 of net capital gains resulting from in-kind redemptions—in which shareholders exchanged fund shares for securities held by the fund rather than for cash. Because such gains are not taxable to the fund, and are not distributed to shareholders, they have been reclassified from accumulated net realized losses to paid-in capital.

At February 28, 2015, the cost of investment securities for tax purposes was $670,429,000.

Net unrealized appreciation of investment securities for tax purposes was $8,578,000, consisting of unrealized gains of $8,881,000 on securities that had risen in value since their purchase and $303,000 in unrealized losses on securities that had fallen in value since their purchase.

E. During the six months ended February 28, 2015, the fund purchased $337,398,000 of investment securities and sold $113,825,000 of investment securities, other than temporary cash investments. Purchases and sales include $137,981,000 and $3,199,000, respectively, in connection with in-kind purchases and redemptions of the fund’s capital shares.

F. Capital share transactions for each class of shares were: