Annual Report | August 31, 2016

Vanguard Sector Bond Index Funds

Vanguard Short-Term Government Bond Index Fund

Vanguard Intermediate-Term Government Bond Index Fund

Vanguard Long-Term Government Bond Index Fund

Vanguard Short-Term Corporate Bond Index Fund

Vanguard Intermediate-Term Corporate Bond Index Fund

Vanguard Long-Term Corporate Bond Index Fund

Vanguard Mortgage-Backed Securities Index Fund

 

A new format, unwavering commitment

As you begin reading this report, you’ll notice that we’ve made some improvements to the opening sections—based on feedback from you, our clients.

Page 1 starts with a new ”Your Fund’s Performance at a Glance,” a concise, handy summary of how your fund performed during the period.

In the renamed ”Chairman’s Perspective,” Bill McNabb will focus on enduring principles and investment insights.

We’ve modified some tables, and eliminated some redundancy, but we haven’t removed any information.

At Vanguard, we’re always looking for better ways to communicate and to help you make sound investment decisions. Thank you for entrusting your assets to us.

 

Please note: The opinions expressed in this report are just that—informed opinions. They should not be considered promises or advice. Also, please keep in mind that the information and opinions cover the period through the date on the front of this report. Of course, the risks of investing in your fund are spelled out in the prospectus.

See the Glossary for definitions of investment terms used in this report.

About the cover: No matter what language you speak, Vanguard has one consistent message and set of principles. Our primary focus is on you, our clients. We conduct our business with integrity as a faithful steward of your assets. This message is shown translated into seven languages, reflecting our expanding global presence.

 

Your Fund’s Performance at a Glance

• Bonds provided a safe harbor from stock market volatility during the 12 months ended August 31, 2016. In June, amid uncertainty surrounding the U.K. Brexit vote, the broad U.S. bond market returned almost 2%, its best month of the fiscal year.

• Several of the funds covered in this report met their investment objective of closely tracking their benchmark indexes, after expenses. Divergences can arise because the funds and their indexes value securities at slightly different times toward the end of the day and use different pricing methods.

• Short-term interest rates rose, but longer-term rates declined—boosting long-term bond prices. (Rates and bond prices move in opposite directions.)

• Returns for ETF Shares (based on net asset value) ranged from about 1% for the Short-Term Government Bond Index Fund to more than 18% for the Long-Term Corporate Bond Index Fund. Both income and capital returns were positive for each fund.

 

Intermediate U.S. Government Funds Average: Derived from data provided by Lipper, a Thomson Reuters Company.

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U.S. Mortgage Funds Average: Derived from data provided by Lipper, a Thomson Reuters Company.

Admiral Shares carry lower expenses and are available to investors who meet certain account-balance requirements. Institutional Shares are available to certain institutional investors who meet specific administrative, service, and account-size criteria. The Vanguard ETF® Shares shown are traded on the Nasdaq exchange and are available only through brokers. The table provides ETF returns based on both the Nasdaq market price and the net asset value for a share. U.S. Pat. Nos. 6,879,964; 7,337,138; 7,720,749; 7,925,573; 8,090,646; and 8,417,623.

For the ETF Shares, the market price is determined by the midpoint of the bid-offer spread as of the closing time of the New York Stock Exchange (generally 4 p.m., Eastern time). The net asset value is also determined as of the NYSE closing time. For more information about how the ETF Shares' market prices have compared with their net asset value, visit vanguard.com, select your ETF, and then select the Price and Performance tab. The ETF premium/discount analysis there shows the percentages of days on which the ETF Shares' market price was above or below the NAV.

 

 

General U.S. Government Funds Average: Derived from data provided by Lipper, a Thomson Reuters Company.

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The figures shown represent past performance, which is not a guarantee of future results. (Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at vanguard.com/performance.) Note, too, that both investment returns and principal value can fluctuate widely, so an investor’s shares, when sold, could be worth more or less than their original cost.

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The fund expense ratios shown are from the prospectus dated December 22, 2015, and represent estimated costs for the current fiscal year. For the fiscal year ended August 31, 2016, the funds’ expense ratios were: for the Short-Term Government Bond Index Fund, 0.07% for ETF Shares, 0.07% for Admiral Shares, and 0.05% for Institutional Shares; for the Intermediate-Term Government Bond Index Fund, 0.07% for ETF Shares, 0.07% for Admiral Shares, and 0.05% for Institutional Shares; for the Long-Term Government Bond Index Fund, 0.07% for ETF Shares, 0.07% for Admiral Shares, and 0.05% for Institutional Shares; for the Short-Term Corporate Bond Index Fund, 0.07% for ETF Shares, 0.07% for Admiral Shares, and 0.05% for Institutional Shares; for the Intermediate-Term Corporate Bond Index Fund, 0.07% for ETF Shares, 0.07% for Admiral Shares, 0.05% for Institutional Shares; for the Long-Term Corporate Bond Index Fund, 0.07% for ETF Shares, 0.07% for Admiral Shares, and 0.05% for Institutional Shares; and for the Mortgage-Backed Securities Index Fund, 0.07% for ETF Shares, 0.07% for Admiral Shares, and 0.05% for Institutional Shares. Peer-group expense ratios are derived from data provided by Lipper, a Thomson Reuters Company, and capture information through year-end 2015.

Peer groups: For the Short-Term Government Bond Index Fund, Short U.S. Government Funds; for the Intermediate-Term Government Bond Index Fund, Intermediate U.S. Government Funds; for the Long-Term Government Bond Index Fund, General U.S. Government Funds; for the Short-Term Corporate Bond Index Fund, Short-Intermediate Investment-Grade Debt Funds; for the Intermediate-Term Corporate Bond Index Fund, Core Bond Funds; for the Long-Term Corporate Bond Index Fund, Corporate BBB-Rated Debt Funds; for the Mortgage-Backed Securities Index Fund, U.S. Mortgage Funds.

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Chairman's Perspective

Bill McNabb
Chairman and Chief Executive Officer

Dear Shareholder,

Even as the global economy continued to expand at a slow but sustained pace over the 12 months ended August 31, 2016, a series of disquieting developments highlighted the importance for investors of remaining disciplined.

Chief among them was "Brexit "- the British public's vote to exit the European Union- but plenty of others moved the markets as well. We saw sharp ups and downs in the prices of oil and other commodities, choppy U.S. job numbers, shifting expectations about when the Federal Reserve might raise interest rates again, and decreases in already negative yields for European and Japanese government bonds.

Beyond being the end of the fiscal period, August marked a milestone: 40 years since Vanguard introduced the first index mutual fund. In ways that are perhaps still not fully appreciated. indexing has vastly improved investing for individuals, advisors, and institutions all over the world. Later in this letter. I'll discuss the revolution wrought by what was initially a little-heralded new fund from a fledgling outfit in Valley Forge, Pennsylvania.

Brexit added another layer of uncertainty for investors

I think it' s fair to say that the momentous June 23 Brexit vote caught even the British off guard. Although we saw some market jitters in the run-up to the referendum, the unexpected outcome triggered a spike in

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volatility worldwide. Stocks around the world lost 5%-10% in U.S. dollar terms in the first two trading sessions following the vote, with U.K. and European markets among the hardest hit; global bonds, though, headed in the other direction. It was a textbook illustration of the value of having a diversified portfolio.

That kind of volatility can push investors to "do something." But some of the worst days in the stock markets are sometimes followed by some of the best-as happened at the end of June. Investors who scrambled to protect their portfolios by shedding stocks amid head lines warning of a global market meltdown may well have ended up locking in post-Brexit losses, then missing out on the strong rebound that took place

 

just days later. Those headlines were noise that investors would have been better off tuning out. I'm pleased to say that Vanguard investors on the whole did just that- we continued to see cashflows in to our funds in the days after the vote.

For the 12 months, stocks generally finished higher, with U.S. stocks up more than 11 % and international stocks about 3% for U.S.-based investors.

In a surprise, bonds turned in a solid performance that few would have predicted a year ago. It seemed as if rates had fallen so far that they couldn't go any lower, but many did. Central banks in a number of European countries and Japan set key monetary policy rates below zero.

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When being 'average' is a lot better than average

Not only did Vanguard founder John C. Bogle launch the first index mutual fund in 1976, but he also was among the first to clearly explain to the investing public the benefits of what was then a novel, unproven strategy.

Back in 1977, in the first annual report for what was later renamed Vanguard 500 Index Fund, Mr. Bogle wrote that an index fund "represents a tough and demanding 'par.'... And if there are some professionals who can 'beat par' more often than not- in investing or in golf- they do not seem to be in the majority."

Mr. Bogle's analogy has been borne out by historical returns. As you can see in the chart below, out of 1,238 actively managed large-capitalization funds, a clear majority-65%-trailed the Standard & Poor's 500 Index in average annual return over the decade ended December 31, 2015. And 518 funds, or about 42% of the total number, trailed by more than 1 percentage point.

The track record looks even more discouraging when you consider that of the 35% of funds that outperformed the index, only 119- or about 10% in all- did so by more than 1 percentage point. The 315 others also took on risk to try to outperform the index (and likely experienced greater volatility) but came out ahead by less than 1 percentage point in average annual return.

Notes: Databased on average annual returns of all 1,238 existing actively managed large-cap funds over the decade ended December 31, 2015. Note that index funds seek to track the performance of a benchmark index but typically won' t "match" the benchmark's returns because of the costs of passive indexing.

Sources: Vanguard calculations. using data from Standard & Poor·s.

Past performance is not a guarantee of future results. The performance of an index is not an exact representation of any particular investment. as you cannot invest directly in an index.

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These policies held down short-term rates, while more muted expectations for global growth and inflation weighed on longer-term rates.

Yields in the United States weren't quite as low as in many developed countries. The Fed raised the federal funds target rate only once, in December, to a slim 0.25%-0.5%. Further out on the maturity spectrum, the bellwether 10-year U.S. Treasury yield dropped in early July to a record low 1.36%, before moving back up a little to end the period at 1.58%. Over the 12 months, U.S. bonds returned about 6%, and international bonds returned even more- about 11%-for U.S.-based investors, again underscoring the markets' unpredictability and the merits of diversification.

Over the years, many investors have embraced the pluses of indexing

Market upsets like Brexit aren't rare occurrences. Fortunately, indexing has proved to be a durable behavioral tool to help keep investors from making bad financial decisions when upsets happen. In fact, this is one of indexing's less appreciated benefits: Holding index funds as part of a broadly diversified portfolio can counterbalance that tendency to react to news headlines. When times are volatile, you'll know you might have some exposure to a part of the market that has dropped, but also to other parts that may be holding up better.

Vanguard's launch of the First Index Investment Trust, now Vanguard 500 Index Fund, initially met with a frosty reception. Its mandate to track the performance of a broadly diversified benchmark at a low cost seemed underwhelming to an investing public accustomed to funds that offered the chance to outperform. Investors have since come around, as experience has demonstrated the benefits of low costs and broad diversification.

Indexing accounted for about 30% of U.S. mutual fund and exchange-traded fund (ETF) assets at the end of 2015, according to the Investment Company Institute. Some now even proclaim the "triumph of indexing," implying that it's theonly way to invest.

In our view, the rise of indexing has served to underscore an investment principle that long predates 1976: A long-term, low -cost, diversified approach gives investors thebest chance for success. That's true whether the investments you choose are indexed or actively managed-or both.

As always, thank you for investing with Vanguard.

F. William McNabb Ill
Chairman and Chief Executive Officer
September 9, 2016

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Short-Term Government Bond Index Fund

 

The agency and mortgage-backed securities sectors may include issues from government-sponsored enterprises; such issues are generally not backed by the full faith and credit of the U.S. government.

 

These measures show the degree and timing of the fund’s fluctuations compared with the indexes over 36 months.

 

Credit-quality ratings are obtained from Barclays and are from Moody's, Fitch, and S&P. When ratings from all three agencies are used, the median rating is shown. When ratings from two of the agencies are used, the lower rating for each issue is shown. "Not Rated" is used to classify securities for which a rating is not available. For more information about these ratings, see the Glossary entry for Credit Quality.

Investment Focus

1 The expense ratios shown are from the prospectus dated December 22, 2015, and represent estimated costs for the current fiscal year. For the fiscal year ended August 31, 2016, the expense ratios were 0.07% for ETF Shares, 0.07% for Admiral Shares, and 0.05% for Institutional Shares.

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Short-Term Government Bond Index Fund

Performance Summary

All of the returns in this report represent past performance, which is not a guarantee of future results that may be achieved by the fund. (Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at vanguard.com/performance.) Note, too, that both investment returns and principal value can fluctuate widely, so an investor’s shares, when sold, could be worth more or less than their original cost. The returns shown do not reflect taxes that a shareholder would pay on fund distributions or on the sale of fund shares.

Cumulative Performance: November 19, 2009, Through August 31, 2016
Initial Investment of $10,000

 

For a benchmark description, see the Glossary.

Short U.S. Government Funds Average: Derived from data provided by Lipper, a Thomson Reuters Company.

"Since Inception" performance is calculated from the ETF Shares’ inception date for both the fund and its comparative standards.

See Financial Highlights for dividend and capital gains information.

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"Since Inception" performance is calculated from the Admiral Shares’ inception date for both the fund and its comparative standards.

 

"Since Inception" performance is calculated from the Institutional Shares’ inception date for both the fund and its comparative standards.

 

"Since Inception" performance is calculated from the ETF Shares’ inception date for both the fund and its comparative standards.

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Average Annual Total Returns: Periods Ended June 30, 2016

This table presents returns through the latest calendar quarter—rather than through the end of the fiscal period.

Securities and Exchange Commission rules require that we provide this information.

 

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Short-Term Government Bond Index Fund

Financial Statements

Statement of Net Assets
As of August 31, 2016

The fund reports a complete list of its holdings in regulatory filings four times in each fiscal year, at the quarter-ends. For the second and fourth fiscal quarters, the lists appear in the fund’s semiannual and annual reports to shareholders. For the first and third fiscal quarters, the fund files the lists with the Securities and Exchange Commission on Form N-Q. Shareholders can look up the fund’s Forms N-Q on the SEC’s website at sec.gov. Forms N-Q may also be reviewed and copied at the SEC’s Public Reference Room (see the back cover of this report for further information).

 

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• See Note A in Notes to Financial Statements.

1 U.S. government-guaranteed.

2 The issuer operates under a congressional charter; its securities are generally neither guaranteed by the U.S. Treasury nor backed by the full faith and credit of the U.S. government.

3 The issuer was placed under federal conservatorship in September 2008; since that time, its daily operations have been managed by the Federal Housing Finance Agency and it receives capital from the U.S. Treasury, as needed to maintain a positive net worth, in exchange for senior preferred stock.

4 Affiliated money market fund available only to Vanguard funds and certain trusts and accounts managed by Vanguard. Rate shown is the 7-day yield.

See accompanying Notes, which are an integral part of the Financial Statements.

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1 Interest income and realized net gain (loss) from an affiliated company of the fund were $60,000 and ($1,000), respectively.

See accompanying Notes, which are an integral part of the Financial Statements.

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1 Includes fiscal 2016 and 2015 short-term gain distributions totaling $200,000 and $149,000, respectively. Short-term gain distributions are treated as ordinary income dividends for tax purposes.

2 Net Assets—End of Period includes undistributed (overdistributed) net investment income of $716,000 and $361,000.

See accompanying Notes, which are an integral part of the Financial Statements.

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1 Excludes the value of portfolio securities received or delivered as a result of in-kind purchases or redemptions of the fund’s capital shares, including ETF Creation Units.

See accompanying Notes, which are an integral part of the Financial Statements.

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Signal Shares were renamed Admiral Shares in October 2013. Prior periods’ Financial Highlights are for the Signal class.

1 Total returns do not include transaction or account service fees that may have applied in the periods shown. Fund prospectuses provide information about any applicable transaction and account service fees.

2 Excludes the value of portfolio securities received or delivered as a result of in-kind purchases or redemptions of the fund’s capital shares, including ETF Creation Units.

See accompanying Notes, which are an integral part of the Financial Statements.

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