UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM N-CSR

CERTIFIED SHAREHOLDER REPORT
OF
REGISTERED MANAGEMENT INVESTMENT COMPANIES

Investment Company Act file number: 811-4681

Name of Registrant: Vanguard Bond Index Funds
Address of Registrant:
P.O. Box 2600
Valley Forge, PA 19482

Name and address of agent for service:
Heidi Stam, Esquire
P.O. Box 876
Valley Forge, PA 19482

Registrant’s telephone number, including area code: (610) 669-1000

Date of fiscal year end: December 31

Date of reporting period: January 1, 2010 – December 31, 2010

Item 1: Reports to Shareholders

 

 

 

 

> All sectors of the broad U.S. bond market posted positive returns for the fiscal year ended December 31, 2010, with lower-quality bonds in the lead.

> The returns of all four Vanguard Bond Index Funds were in line with those of their target indexes. Results for Investor Shares ranged from 3.92% for the Short-Term Bond Index Fund to 10.27% for the Long-Term Bond Index Fund.

> For the decade ended December 31, each fund’s average annual return outpaced that of its respective peer-group average by a margin considered significant in the world of fixed income investing.

 

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.

Cover photograph: Jean Maher.

 

Your Fund’s Total Returns

Fiscal Year Ended December 31, 2010

Spliced Barclays Capital U.S. Aggregate Float Adjusted Index: Barclays Capital U.S. Aggregate Bond Index through December 31, 2009; Barclays Capital U.S. Aggregate Float Adjusted Index thereafter.

Spliced Intermediate Investment-Grade Funds Average: Based on average returns for Intermediate U.S. Government Funds through December 31, 2001, and average returns for Intermediate Investment Grade Debt Funds thereafter. Derived from data provided by Lipper Inc.

The inception date of the Institutional Plus Shares is February 5, 2010. For the period ended December 31, 2010, the returns and other data shown in the table above reflect a blend of the historical performance of the fund's Institutional Shares prior to February 5, 2010, and of the Institutional Plus Shares from then on.

Spliced Barclays Capital U.S. 1–5 Year Government/Credit Float Adjusted Index: Barclays Capital U.S. 1–5 Year Government/Credit Bond Index through December 31, 2009; Barclays Capital U.S. 1–5 Year Government/Credit Float Adjusted Index thereafter.

Spliced 1–5 Year Investment-Grade Debt Funds Average: Based on average returns for 1–5 Year U.S. Government Funds through December 31, 2001, and average returns for 1–5 Year Investment Grade Debt Funds thereafter. Derived from data provided by Lipper Inc.

Admiral Shares carry lower expenses and are available to investors who meet certain account-balance requirements. Signal, Institutional, and Institutional Plus 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 NYSE Arca exchange and are available only through brokers. The table provides ETF returns based on both the NYSE Arca market price and the net asset value for a share. U.S. Pat. No. 6,879,964 B2; 7,337,138.

1

 

Your Fund’s Total Returns

Fiscal Year Ended December 31, 2010

Spliced Barclays Capital U.S. 5–10 Year Government/Credit Float Adjusted Index: Barclays Capital U.S. 5–10 Year Government/Credit Bond Index through December 31, 2009; Barclays Capital U.S. 5–10 Year Government/Credit Float Adjusted Index thereafter.

Spliced Intermediate Investment-Grade Funds Average: Based on average returns for Intermediate U.S. Government Funds through December 31, 2001, and average returns for Intermediate Investment Grade Debt Funds thereafter. Derived from data provided by Lipper Inc.

Spliced Barclays Capital U.S. Long Government/Credit Float Adjusted Index: Barclays Capital U.S. Long Government/Credit Bond Index through December 31, 2009; Barclays Capital U.S. Long Government/Credit Float Adjusted Index thereafter.

Spliced Corporate A-Rated Debt Funds Average: Based on average returns for General Government Funds through December 31, 2001, and the average returns for Corporate A-Rated Debt Funds thereafter. Derived from data provided by Lipper Inc.

Admiral Shares carry lower expenses and are available to investors who meet certain account-balance requirements. Signal, Institutional, and Institutional Plus 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 NYSE Arca exchange and are available only through brokers. The table provides ETF returns based on both the NYSE Arca market price and the net asset value for a share. U.S. Pat. No. 6,879,964 B2; 7,337,138.

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.

2

 

Your Fund’s Performance at a Glance

December 31, 2009 , Through December 31, 2010

 

The inception date of the Institutional Plus Shares is February 5, 2010. For the period ended December 31, 2010, the returns and other data shown in the table above reflect a blend of the historical performance of the fund's Institutional Shares prior to February 5, 2010, and of the Institutional Plus Shares from then on.

3

 

Chairman’s Letter

Dear Shareholder,

With the shortest-term interest rates anchored near zero by Federal Reserve policy, yield-hungry investors in 2010 reached farther out along the maturity curve and farther down the credit-quality ladder, boosting bond prices. Echoing 2009, for the most part, the lower the quality the higher the return. But, in bright contrast to last year, all major sectors of the fixed income market posted positive returns.

In this environment, the Long-Term Bond Index Fund moved from last place among the four Vanguard Bond Index Funds in 2009 to first place in 2010, with a return of 10.27%. Not far behind was the Intermediate-Term Bond Index Fund, with a return of 9.37%, followed by the Total Bond Market Index Fund’s 6.42% return. The Short-Term Bond Index Fund brought up the rear with a return of 3.92%. Within each fund, capital gains and investment income made roughly similar contributions to total return.

Please note: As part of our ongoing efforts to lower the cost of investing for all of our clients, we have broadened the availability of our lower-cost Admiral Shares, reducing the Admiral minimums for most of our broad-market index funds from $100,000 to $10,000. In addition, we have eliminated the minimum investment requirement for Signal Shares for certain clients.

4

 

The fixed income market reprised a familiar theme
Although U.S. Treasury securities rallied through the summer, total return tables were dominated by riskier bonds for the full 12 months, a pattern we also saw in 2009. Low interest rates and a sense that the economic recovery was gathering momentum prompted investors to seek higher yields in both high-quality and below-investment-grade corporate bonds. The broad U.S. bond market returned 6.54%. Late in the year, yields bounced off summer lows, putting pressure on bond prices. The dynamic was especially pronounced among municipal bonds.

As it has since December 2008, the Fed held its target for short-term interest rates near 0%, keeping the returns available from money market instruments such as the 3-month Treasury bill in the same neighborhood.

Stocks rallied as the forecast seemed to brighten
After a series of false starts, hesitations, and retreats, global stock markets finished 2010 with powerful gains. As the prospect of a double-dip recession faded, the broad U.S. stock market clambered higher, shrugging off high unemployment and distress in Europe’s debt markets to return 17.70%. Small- and mid-capitalization stocks did even better.

 

5

 

Outside the United States, gains were more muted, in part because Europe’s sovereign debt challenges continued to reverberate through local stock markets. Emerging markets were the best performers. Asia’s developed markets performed weakly, though the strength of the yen, the Australian dollar, and other regional currencies bolstered returns for U.S.-based investors.

Not a straight line, but another good year
The four Vanguard Bond Index Funds are designed to produce returns that closely track those of their designated segments of the investment-grade bond market. Each fund therefore has a sizable stake in U.S. Treasury and government agency bonds—consistent with those bonds’ representation in the target Barclays float adjusted indexes. The Short-Term Bond Index held the largest Treasury and agency position—more than 70% of total assets at year-end. At the other end of the scale, these bonds accounted for more than 40% of the Long-Term and Total Bond Index Funds—still a large slice of total assets.

The various bond market segments moved in and out of favor with investors during the year. In the first six months, jitters about European debt and slower growth in the U.S. economy made the safety of Treasuries more appealing to investors—even though that meant forgoing potentially higher returns. In the second half, however, as investors became more optimistic, their appetite for risk returned.

Expense Ratios
Your Fund Compared With Its Peer Group

The fund expense ratios shown are from the prospectus dated April 27, 2010, and represent estimated costs for the current fiscal year. For the fiscal year ended December 31, 2010, the funds’ expense ratios were: for the Total Bond Market Index Fund, 0.22% for Investor Shares, 0.11% for Admiral Shares, 0.11% for Signal Shares, 0.07% for Institutional Shares, 0.05% for Institutional Plus Shares, and 0.11% for ETF Shares; for the Short-Term Bond Index Fund, 0.22% for Investor Shares, 0.11% for Admiral Shares, 0.11% for Signal Shares, and 0.11% for ETF Shares; for the Intermediate-Term Bond Index Fund, 0.22% for Investor Shares, 0.11% for Admiral Shares, 0.11% for Signal Shares, 0.07% for Institutional Shares, and 0.11% for ETF Shares; and for the Long-Term Bond Index Fund, 0.22% for Investor Shares, 0.07% for Institutional Shares, and 0.11% for ETF Shares. Peer-group expense ratios are derived from data provided by Lipper Inc. and capture information through year-end 2009.

Peer groups: For the Total Bond Market Index Fund, Intermediate-Term Investment-Grade Debt Funds; for the Short-Term Bond Index Fund, 1–5 Year Investment-Grade Debt Funds; for the Intermediate-Term Bond Index Fund, Imtermediate-Term Investment-Grade Debt Funds; for the Long-Term Bond Index Fund, Corporate A-Rated Debt Funds.

6

 

Total Returns
Ten Years Ended December 31, 2010

Spliced Barclays Capital U.S. Aggregate Float Adjusted Index: Barclays Capital U.S. Aggregate Bond Index through December 31, 2009; Barclays Capital U.S. Aggregate Float Adjusted Index thereafter.

Spliced Intermediate Investment-Grade Funds Average: Based on average returns for Intermediate U.S. Government Funds through December 31, 2001, and average returns for Intermediate Investment Grade Debt Funds thereafter. Derived from data provided by Lipper Inc.

Spliced Barclays Capital U.S. 1–5 Year Government/Credit Float Adjusted Index: Barclays Capital U.S. 1–5 Year Government/Credit Bond Index through December 31, 2009; Barclays Capital U.S. 1–5 Year Government/Credit Float Adjusted Index thereafter.

Spliced 1–5 Year Investment-Grade Debt Funds Average: Based on average returns for 1–5 Year U.S. Government Funds through December 31, 2001, and average returns for 1–5 Year Investment Grade Debt Funds thereafter. Derived from data provided by Lipper Inc.

Spliced Barclays Capital U.S. 5–10 Year Government/Credit Float Adjusted Index: Barclays Capital U.S. 5–10 Year Government/Credit Bond Index through December 31, 2009; Barclays Capital U.S. 5–10 Year Government/Credit Float Adjusted Index thereafter.

Spliced Intermediate Investment-Grade Funds Average: Based on average returns for Intermediate U.S. Government Funds through December 31, 2001, and average returns for Intermediate Investment Grade Debt Funds thereafter. Derived from data provided by Lipper Inc.

Spliced Barclays Capital U.S. Long Government/Credit Float Adjusted Index: Barclays Capital U.S. Long Government/Credit Bond Index through December 31, 2009; Barclays Capital U.S. Long Government/Credit Float Adjusted Index thereafter.

Spliced Corporate A-Rated Debt Funds Average: Based on average returns for General Government Funds through December 31, 2001, and the average returns for Corporate A-Rated Debt Funds thereafter. Derived from data provided by Lipper Inc.

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.

7

 

For the year as a whole, corporate bonds returned about 9%, overtaking the almost 6% return of Treasuries, giving a relative boost to funds with higher levels of corporate holdings. Yield spreads of corporate and other bonds relative to Treasuries generally continued to come back into line with historical norms after spiking during the financial crisis. The year-over-year change in 30-day SEC yields was most notable in the Intermediate-Term Bond Index Fund (3.17% at December 31, 2010, down from 3.85%) and the Total Bond Index Fund (2.68%, down from 3.33%).

Indexing skill and low costs support long-term results
For the ten years ended December 31, 2010, the Long-Term Bond Index Fund’s 7.11% average annual return was again the highest of the four funds in this report. In a period marked by disappointing stock performance and exceptionally strong bond returns, the 5.57% average annual return of the Total Bond Market Index Fund outpaced that of the broad U.S. stock market (2.64% for the Dow Jones U.S. Total Stock Market Index).

Each fund’s result outperformed that of its respective peer-group average for the decade, in part reflecting the competitive advantage of low costs—which enable investors to keep more of a fund’s return. Importantly, all four of the Vanguard Bond Index Funds also met the objective of closely tracking the return of their target index, which of course incurs no expenses. Close index tracking, whether markets are up or down, is the hallmark of a successful index fund. The funds’ long-term performance record is a tribute to the experienced team of portfolio managers, traders, risk managers, and credit analysts of Vanguard Fixed Income Group who have ably guided the funds.

With interest rates near generational lows, it seems reasonable to assume that the next move may be up—which could hurt bond returns in the short term—but a rate rise is by no means preordained. Absent a crystal ball, diversification may be the next best thing. And your portfolio should be appropriately balanced consistent with your investment goals, time horizon, and risk tolerance. Any one or more of the Vanguard Bond Index Funds—which are low-cost, broadly diversified index funds that seek to track the performance of their respective segments of the investment-grade bond market—can play an important role within such a portfolio.

Thank you for entrusting your assets to Vanguard.

Sincerely,

F. William McNabb III
President and Chief Executive Officer
January 13, 2011

8

 

Total Bond Market Index Fund

Fund Profile
As of December 31, 2010

 

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

 

 

1 The expense ratios shown are from the prospectus dated April 27, 2010, and represent estimated costs for the current fiscal year. For the fiscal year ended December 31, 2010, the expense ratios were 0.22% for Investor Shares, 0.11% for Admiral Shares, 0.11% for Signal Shares, 0.07% for Institutional Shares, 0.05% for Institutional Plus Shares, and 0.11% for ETF Shares.

9

 

Total Bond Market Index Fund

 

Investment Focus

10

 

 

	Average Annual Total Returns
	Periods Ended December 31, 2010
				Final Value
	One	Five	Ten	of a $10,000
	Year	Years	Years	Investment
Total Bond Market Index Fund
Investor Shares	6.42%	5.72%	5.57%	$17,200
Spliced Barclays Capital U.S.
Aggregate Float Adjusted Index	6.58	5.81	5.84	17,640
Spliced Intermediate Investment-Grade
Funds Average	7.70	4.66	4.83	16,024

			Since	Final Value
	One	Five	Inception	of a $10,000
	Year	Years	(11/12/2001)	Investment
Total Bond Market Index Fund
Admiral Shares	6.54%	5.82%	5.04%	$15,668
Spliced Barclays Capital U.S.
Aggregate Float Adjusted Index	6.58	5.81	5.23	15,932

 

Total Bond Market Index Fund

 

The inception date of the Institutional Plus Shares is February 5, 2010. For the period ended December 31, 2010, the returns and other data shown in the table above reflect a blend of the historical performance of the fund's Institutional Shares prior to February 5, 2010, and of the Institutional Plus Shares from then on.

 

 

12

 

Total Bond Market Index Fund

Cumulative Returns of ETF Shares: April 3, 2007, Through December 31, 2010

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

Fiscal-Year Total Returns (%): December 31, 2000, Through December 31, 2010

Spliced Barclays Capital U.S. Aggregate Float Adjusted Index: Barclays Capital U.S. Aggregate Bond Index through December 31, 2009; Barclays Capital U.S. Aggregate Float Adjusted Index thereafter.

13

 

Total Bond Market Index Fund

Financial Statements

Statement of Net Assets—Investments Summary
As of December 31, 2010

This Statement summarizes the fund’s holdings by asset type. Details are reported for each of the fund’s 50 largest individual holdings and for investments that, in total for any issuer, represent more than 1% of the fund’s net assets. The total value of smaller holdings is reported as a single amount within each category.

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 complete listing of the fund’s holdings is available electronically on vanguard.com and on the Securities and Exchange Commission’s website (sec.gov), or you can have it mailed to you without charge by calling 800-662-7447. For the first and third fiscal quarters, the fund files the lists with the SEC on Form N-Q. Shareholders can look up the fund’s Forms N-Q on the SEC’s website. 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).

 

14

 

Total Bond Market Index Fund

 

15

 

Total Bond Market Index Fund

 

16

 

Total Bond Market Index Fund

At December 31, 2010, net assets consisted of:

 

17

 

	Amount
	($000)
Institutional Plus Shares—Net Assets
Applicable to 599,854,287 outstanding $.001 par value shares of
beneficial interest (unlimited authorization)	6,357,983
Net Asset Value Per Share—Institutional Plus Shares	10.60
ETF Shares—Net Assets
Applicable to 112,800,000 outstanding $.001 par value shares of
beneficial interest (unlimited authorization)	9,047,790
Net Asset Value Per Share—ETF Shares	80.21

 

Total Bond Market Index Fund

Statement of Operations

 

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

19

 

Total Bond Market Index Fund

Statement of Changes in Net Assets

1 Includes fiscal 2010 short-term gains distributions totaling $130,494,000. Short-term gains distributions are treated as ordinary income dividends for tax purposes.

 

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

20

 

Total Bond Market Index Fund

Financial Highlights

Investor Shares

1 Total returns do not include account service fees that may have been applied in the periods shown. Fund prospectuses provide information about any applicable 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.  
3  Includes 28% that is attributable to mortgage-dollar-roll activity.

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

21

 

Total Bond Market Index Fund

Financial Highlights

Admiral Shares

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.  
2  Includes 28% that is attributable to mortgage-dollar-roll activity.  

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

22

 

Total Bond Market Index Fund

Financial Highlights

Signal Shares

1  Inception.

2  Annualized.
3  Excludes the value of portfolio securities received or delivered as a result of in-kind purchases or redemptions of the fund's captial shares, including ETF Creation Units.  
4  Includes 28% that is attributable to mortgage-dollar-roll activity.  

 

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

23

 

Total Bond Market Index Fund

Financial Highlights

Institutional Shares

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.
2  Includes 28% that is attributable to mortgage-dollar- roll activity.  

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

24

 

Total Bond Market Index Fund

Financial Highlights

Institutional Plus Shares

1  Inception. See Note G in Notes to Financial Statements.  
2  Annualized.
3  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. 
4  Includes 28% that is attributable to mortgage- dollar-roll activity.  

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

25

 

Total Bond Market Index Fund

Financial Highlights

ETF Shares

1  Inception.
2  Annualized. 
3  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. 
4  Includes 28% that is attributable to mortgage- dollar- roll activity. 

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

26

 

Total Bond Market Index Fund

Notes to Financial Statements

Vanguard Total Bond Market Index Fund is registered under the Investment Company Act of 1940 as an open-end investment company, or mutual fund. Certain of the fund’s investments are in corporate debt instruments; the issuers’ abilities to meet their obligations may be affected by economic developments in their respective industries. The fund offers six classes of shares: Investor Shares, Admiral Shares, Signal Shares, Institutional Shares, Institutional Plus Shares, and ETF Shares. Investor Shares are available to any investor who meets the fund’s minimum purchase requirements. Admiral Shares, Signal Shares, Institutional Shares, and Institutional Plus Shares are designed for investors who meet certain administrative, service, and account-size criteria. ETF Shares are listed for trading on the NYSE Arca, Inc.; they can be purchased and sold through a broker.

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

1. Security Valuation: 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. To Be Announced (TBA) Transactions: A TBA transaction is an agreement to buy or sell mortgage-backed securities with agreed upon characteristics (face amount, coupon, maturity) for settlement at a future date. The fund may enter into TBA sells to reduce its exposure to the mortgage-backed securities market or in order to dispose of mortgage-backed securities it owns under delayed delivery arrangements. For TBA purchases, the fund maintains cash or short-term investments until settlement date in an amount sufficient to meet the purchase price.

3. Mortgage Dollar Rolls: The fund has entered into mortgage-dollar-roll transactions, in which the fund sells mortgage-backed securities to a dealer and simultaneously purchases similar securities for future settlement at a lower price. The proceeds of the securities sold in mortgage-dollar-roll transactions are typically invested in high-quality short-term fixed income securities. Although the fund forgoes principal and interest paid on the securities sold, it is compensated by interest earned on the sale proceeds and by a lower price on the securities to be repurchased. The fund has also entered into mortgage-dollar-roll transactions, in which the fund buys securities from a dealer pursuant to a TBA transaction and simultaneously sells similar securities for future settlement. The securities bought in mortgage-dollar-roll transactions are used to cover an open TBA sell position. The fund continues to earn interest on mortgage-backed security pools already held and receives a lower price on the securities to be sold in the future. The fund accounts for mortgage-dollar-roll transactions as purchases and sales; as such, these transactions may increase the fund’s portfolio turnover rate. Amounts to be received or paid in connection with open mortgage dollar rolls are included in Receivables for Investment Securities Sold (Other Assets) or Payables for Investment Securities Purchased (Liabilities) in the Statement of Net Assets. The primary risk associated with mortgage dollar rolls is that a counterparty will default on its obligations. This risk is mitigated by entering into mortgage dollar rolls with only highly rated counterparties, allocating transactions among numerous counterparties, and monitoring exposure to each counterparty.

27

 

Total Bond Market Index Fund

4. 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 (December 31, 2007–2010), and has concluded that no provision for federal income tax is required in the fund’s financial statements.

5. Distributions: Distributions from net investment income are declared daily by all share classes except ETF Shares, and paid on the first business day of the following month. Monthly income dividends from ETF Shares, and annual distributions from realized capital gains, if any, are recorded on the ex-dividend date.

6. Security Lending: The fund may lend its securities to qualified institutional borrowers to earn additional income. Security loans are required to be secured at all times by collateral at least equal to the market value of securities loaned. The fund invests cash collateral received in Vanguard Market Liquidity Fund, and records a liability for the return of the collateral, during the period the securities are on loan. Security lending income represents fees charged to borrowers plus income earned on investing cash collateral, less expenses associated with the loan.

7. 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 expenses are allocated to each class of shares based on a method approved by the board of trustees. Income, other non-class-specific expenses, and gains and losses on investments are allocated to each class of shares based on its relative net assets.

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 under methods approved by the board of trustees. The fund has committed to provide up to 0.40% of its net assets in capital contributions to Vanguard. At December 31, 2010, the fund had contributed capital of $15,664,000 to Vanguard (included in Other Assets), representing 0.02% of the fund’s net assets and 6.26% 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).

28

 

Total Bond Market Index Fund

The following table summarizes the fund’s investments as of December 31, 2010, based on the inputs used to value them:

 

The following table summarizes changes in investments valued based on Level 3 inputs during the year ended December 31, 2010:

 

D. Capital gain distributions are determined on a tax basis and may differ from realized capital gains for financial reporting purposes. Differences may be permanent or temporary. Permanent differences are reclassified among capital accounts in the financial statements to reflect their tax character. Temporary differences arise when gains or losses are recognized in different periods for financial statement and tax purposes; these differences will reverse at some time in the future.

During the year ended December 31, 2010, the fund realized $7,459,000 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.

The fund used a tax accounting practice to treat a portion of the price of capital shares redeemed during the year as distributions from realized capital gains. Accordingly, the fund has reclassified $30,434,000 from accumulated net realized losses to paid-in capital.

The fund acquired additional realized losses of $762,000 to offset future capital gains in connection with the acquisition of Institutional Total Bond Market Index Fund in February 2010 (See Note G); these losses have been reclassified from paid-in capital to accumulated net realized losses. The fund used capital loss carryforward of $96,531,000 to offset taxable capital gains realized during the year ended December 31, 2010, reducing the amount of capital gains that would otherwise be available to distribute to shareholders.

29

 

Total Bond Market Index Fund

At December 31, 2010, the cost of investment securities for tax purposes was $84,474,015,000. Net unrealized appreciation of investment securities for tax purposes was $3,089,436,000, consisting of unrealized gains of $3,398,905,000 on securities that had risen in value since their purchase and $309,469,000 in unrealized losses on securities that had fallen in value since their purchase.

E. During the year ended December 31, 2010, the fund purchased $7,931,752,000 of investment securities and sold $2,971,350,000 of investment securities, other than U.S. government securities and temporary cash investments. Purchases and sales of U.S. government securities were $68,975,251,000 and $57,473,152,000, respectively.

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

 

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Total Bond Market Index Fund

 

G. As of the close of business on February 5, 2010, the fund acquired all the net assets of Vanguard Institutional Total Bond Market Index Fund pursuant to a plan of reorganization approved by the funds’ board of trustees. The acquisition was accomplished by a tax-free exchange of 403,613,000 shares of the fund for 80,272,000 shares of Institutional Total Bond Market Index Fund outstanding as of the close of business on February 5, 2010. Shares of Institutional Total Bond Market Index Fund were exchanged for new Institutional Plus Shares of the fund. The Institutional Total Bond Market Index Fund’s net assets as of the close of business on February 5, 2010, of $4,235,240,000, including $134,921,000 of unrealized appreciation, were combined with the fund’s net assets. The net assets of the fund immediately before the acquisition were $70,363,886,000. The net assets of the fund immediately following the acquisition were $74,599,126,000.

Assuming that the acquisition had been completed on January 1, 2010, the beginning of the fund’s reporting period, the fund’s pro forma results of operations for the year ended December 31, 2010, would be:

 

Because the combined funds have been managed as a single integrated fund since the acquisition was completed, it is not practical to separate the results of operations of Vanguard Institutional Total Bond Market Index Fund that have been included in the fund’s statement of operations since February 5, 2010.

H. In preparing the financial statements as of December 31, 2010, management considered the impact of subsequent events for potential recognition or disclosure in these financial statements.

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