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PART B
VANGUARD WELLESLEY INCOME FUND
(THE FUND)
STATEMENT OF ADDITIONAL INFORMATION
APRIL 21, 2000; REVISED SEPTEMBER 29, 2000
This Statement is not a prospectus but should be read in conjunction with the
Fund's current Prospectus (dated April 21, 2000). To obtain, without charge, the
Prospectus or the most recent Annual Report to Shareholders, which contains the
Fund's financial statements as hereby incorporated by reference, please call:
INVESTOR INFORMATION DEPARTMENT: 1-800-662-7447
TABLE OF CONTENTS
DESCRIPTION OF THE FUND..........................................B-1
INVESTMENT POLICIES..............................................B-3
FUNDAMENTAL INVESTMENT LIMITATIONS...............................B-9
SHARE PRICE......................................................B-10
PURCHASE OF SHARES...............................................B-11
REDEMPTION OF SHARES.............................................B-11
YIELD AND TOTAL RETURN...........................................B-11
MANAGEMENT OF THE FUND...........................................B-13
INVESTMENT ADVISORY SERVICES.....................................B-16
PORTFOLIO TRANSACTIONS...........................................B-19
COMPARATIVE INDEXES..............................................B-20
FINANCIAL STATEMENTS.............................................B-22
APPENDIX--DESCRIPTION OF SECURITIES AND RATINGS..................B-22
DESCRIPTION OF THE FUND
ORGANIZATION
The Fund was organized as a Delaware corporation in 1968, reorganized as a
Maryland corporation in 1973, and then reorganized as a Delaware business trust
in May, 1998. Prior to its reorganization as a Delaware business trust, the Fund
was known as Vanguard/Wellesley Income Fund, Inc. The Fund is registered with
the United States Securities and Exchange Commission (the Commission) under the
Investment Company Act of 1940 (the 1940 Act) as an open-end, diversified
management investment company. It currently offers a single class of shares, but
has the ability to offer additional share classes. There is no limit on the
number of full and fractional shares that the Fund may issue.
SERVICE PROVIDERS
CUSTODIAN. The Chase Manhattan Bank, N.A., 4 Chase MetroTech Center,
Brooklyn, New York 11245 serves as the Fund's custodian. The custodian is
responsible for maintaining the Fund's assets and keeping all necessary accounts
and records of Fund assets.
INDEPENDENT ACCOUNTANTS. PricewaterhouseCoopers LLP, 30 South 17th Street,
Philadelphia, Pennsylvania 19103, serves as the Fund's independent accountants.
The accountants audit financial statements for the Fund and provide other
related services.
TRANSFER AND DIVIDEND-PAYING AGENT. The Fund's transfer agent and
dividend-paying agent is The Vanguard Group, Inc., 100 Vanguard Boulevard,
Malvern, Pennsylvania 19355.
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CHARACTERISTICS OF THE FUND'S SHARES
RESTRICTIONS ON HOLDING OR DISPOSING OF SHARES. There are no restrictions
on the right of shareholders to retain or dispose of the Fund's shares, other
than the possible future termination of the Fund. The Fund\\ \\may be terminated
by reorganization into another mutual fund or by liquidation and distribution of
its assets. Unless terminated by reorganization or liquidation, the Fund will
continue indefinitely.
SHAREHOLDER LIABILITY. The Fund is organized under Delaware law, which
provides that shareholders of a business trust are entitled to the same
limitations of personal liability as shareholders of a corporation organized
under Delaware law. Effectively, this means that a shareholder of the Fund will
not be personally liable for payment of the Fund's debts except by reason of his
or her own conduct or acts. In addition, a shareholder could incur a financial
loss on account of a Fund obligation only if the Fund itself had no remaining
assets with which to meet such obligation. We believe that the possibility of
such a situation arising is extremely remote.
DIVIDEND RIGHTS. The shareholders of the Fund are entitled to receive any
dividends or other distributions declared by the Fund. No shares have priority
or preference over any other shares with respect to distributions. Distributions
will be made from the assets of the Fund, and will be paid ratably to all
shareholders according to the number of shares of held by shareholders on the
record date.
VOTING RIGHTS. Shareholders are entitled to vote on a matter if: (i) a
shareholder vote is required under the 1940 Act; (ii) the matter concerns an
amendment to the Declaration of Trust that would adversely affect to a material
degree the rights and preferences of the shares of any class or fund; or (iii)
the Trustees determine that it is necessary or desirable to obtain a shareholder
vote. The 1940 Act requires a shareholder vote under various circumstances,
including to elect or remove Trustees upon the written request of shareholders
representing 10% or more of the Fund's net assets, and to change any fundamental
policy of the Fund. Shareholders of the Fund receive one vote for each dollar of
net asset value owned on the record date, and a fractional vote for each
fractional dollar of net asset value owned on the record date. Voting rights are
non-cumulative and cannot be modified without a majority vote.
LIQUIDATION RIGHTS. In the event of liquidation, shareholders will be
entitled to receive a pro rata share of the Fund's net assets.
PREEMPTIVE RIGHTS. There are no preemptive rights associated with the
Fund's shares.
CONVERSION RIGHTS. There are no conversion rights associated with the
Fund's shares.
REDEMPTION PROVISIONS. The Fund's redemption provisions are described in
its current prospectus and elsewhere in this Statement of Additional
Information.
SINKING FUND PROVISIONS. The Fund has no sinking fund provisions.
CALLS OR ASSESSMENT. The Fund's shares, when issued, are fully paid and
non-assessable.
TAX STATUS OF THE FUND
The Fund intends to continue to qualify as a "regulated investment company"
under Subchapter M of the Internal Revenue Code. This special tax status means
that the Fund will not be liable for federal tax on income and capital gains
distributed to shareholders. In order to preserve its tax status, the Fund must
comply with certain requirements. If the Fund fails to meet these requirements
in any taxable year, it will be subject to tax on its taxable income at
corporate rates, and all distributions from earnings and profits, including any
distributions of net tax-exempt income and net long-term capital gains, will be
taxable to shareholders as ordinary income. In addition, the Fund could be
required to recognize unrealized gains, pay substantial taxes and interest, and
make substantial distributions before regaining its tax status as a regulated
investment company.
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INVESTMENT POLICIES
The following policies supplement the Fund's investment policies as set forth in
the Prospectus.
REPURCHASE AGREEMENTS. The Fund may invest in repurchase agreements with
commercial banks, brokers or dealers either for defensive purposes due to market
conditions or to generate income from its excess cash balances. A repurchase
agreement is an agreement under which the Fund acquires a fixed-income security
(generally a security issued by the U.S. Government or an agency thereof, a
banker's acceptance or a certificate of deposit) from a commercial bank, broker,
or dealer, subject to resale to the seller at an agreed upon price and date
(normally, the next business day). A repurchase agreement may be considered a
loan collateralized by securities. The resale price reflects an agreed upon
interest rate effective for the period the instrument is held by the Fund and is
unrelated to the interest rate on the underlying instrument. In these
transactions, the securities acquired by the Fund (including accrued interest
earned thereon) must have a total value in excess of the value of the repurchase
agreement and are held by a custodian bank until repurchased. In addition, the
Fund's Board of Trustees will monitor the Fund's repurchase agreement
transactions generally and will establish guidelines and standards for review by
the investment adviser of the creditworthiness of any bank, broker, or dealer
party to a repurchase agreement with the Fund.
The use of repurchase agreements involves certain risks. For example, if
the other party to the agreement defaults on its obligation to repurchase the
underlying security at a time when the value of the security has declined, the
Fund may incur a loss upon disposition of the security. If the other party to
the agreement becomes insolvent and subject to liquidation or reorganization
under bankruptcy or other laws, a court may determine that the underlying
security is collateral for a loan by the Fund not within the control of the Fund
and therefore the realization by the Fund on such collateral may be
automatically stayed. Finally, it is possible that the Fund may not be able to
substantiate its interest in the underlying security and may be deemed an
unsecured creditor of the other party to the agreement. While the adviser
acknowledges these risks, it is expected that they will be controlled through
careful monitoring procedures.
MORTGAGE-BACKED SECURITIES. The Fund may invest in mortgage-backed
securities. Mortgage-backed securities are instruments that entitle the holder
to a share of all interest and principal payments from mortgages underlying the
security. The mortgages backing these securities include conventional
thirty-year fixed rate mortgages, graduated payment mortgages and adjustable
rate mortgages. During periods of declining interest rates, prepayment of
mortgages underlying mortgage-backed securities may be expected to accelerate.
Prepayment of mortgages which underlie securities purchased at a premium often
results in capital losses, while prepayment of mortgages purchased at a discount
often results in capital gains. Because of these unpredictable prepayment
characteristics, it is often not possible to predict accurately the average life
or realized yield of a particular issue.
COLLATERALIZED MORTGAGE OBLIGATIONS. (CMOs) are debt obligations or
multi-class pass-through certificates issued by agencies or instrumentalities of
the U.S. Government, or by private originators or investors in mortgage loans.
In a CMO, series of bonds or certificates are usually issued in multiple
classes, with principal and interest allocated to each class in a variety of
ways. Each class of a CMO, or "tranche," is issued with a specific fixed or
floating coupon rate and has a stated maturity or final distribution date. The
Fund will invest modestly in those CMO classes which feature a high degree of
cash flow predictability and moderate vulnerability to prepayment risk, and that
carry high-quality investment grade credit ratings.
LENDING OF SECURITIES. The Fund may lend its investment securities to
qualified institutional investors (typically brokers, dealers, banks, or other
financial institutions) who need to borrow securities in order to complete
certain transactions, such as covering short sales, avoiding failures to deliver
securities or completing arbitrage operations. By lending its portfolio
securities, the Fund attempts to increase its net investment income through the
receipt of interest on the loan. Any gain
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or loss in the market price of the securities loaned that might occur during the
term of the loan would be for the account of the Fund. The terms, the structure
and the aggregate amount of such loans must be consistent with the 1940 Act, and
the rules or interpretations of the Commission thereunder. These provisions
limit the amount of securities the Fund may lend to 33 1/3% of the Fund's total
assets, and require that (a) the borrower pledge and maintain with the Fund
collateral consisting of cash, an irrevocable letter of credit issued by a
domestic U.S. bank, or securities issued or guaranteed by the United States
Government having a value at all times not less than 100% of the value of the
securities loaned, (b) the borrower add to such collateral whenever the price of
the securities loaned rises (i.e. the borrower "marks to the market" on a daily
basis), (c) the loan be made subject to termination by the Fund at any time, and
(d) the Fund receive reasonable interest on the loan (which may include the
Fund's investing any cash collateral in interest bearing short-term
investments), any distribution on the loaned securities and any increase in
their market value. Loan arrangements made by the Fund will comply with all
other applicable regulatory requirements, including the rules of the New York
Stock Exchange, which rules presently require the borrower, after notice, to
redeliver the securities within the normal settlement time of three business
days. All relevant facts and circumstances, including the creditworthiness of
the broker, dealer or institution, will be considered in making decisions with
respect to the lending of securities, subject to review by the Fund's Board of
Trustees.
At the present time, the Staff of the Commission does not object if an
investment company pays reasonable negotiated fees in connection with loaned
securities, so long as such fees are set forth in a written contract and
approved by the investment company's Trustees. In addition, voting rights pass
with the loaned securities, but if a material event will occur affecting an
investment on loan, the loan must be called and the securities voted.
VANGUARD INTERFUND LENDING PROGRAM. The Commission has issued an exemptive
order permitting the Fund and other Vanguard funds to participate in Vanguard's
interfund lending program. This program allows the Vanguard funds to borrow
money from and loan money to each other for temporary or emergency purposes. The
program is subject to a number of conditions, including the requirement that no
fund may borrow or lend money through the program unless it receives a more
favorable interest rate than is available from a typical bank for a comparable
transaction. In addition, a Vanguard fund may participate in the program only if
and to the extent that such participation is consistent with the fund's
investment objective and other investment policies. The Boards of Trustees of
the Vanguard funds are responsible for ensuring that the interfund lending
program operates in compliance with all conditions of the Commission's exemptive
order.
TEMPORARY INVESTMENTS. The Fund may take temporary defensive measures that
are inconsistent with the Fund's normal fundamental or non-fundamental
investment policies and strategies in response to adverse market, economic,
political or other conditions. Such measures could include investments in (a)
highly liquid short-term fixed-income securities issued by or on behalf of
municipal or corporate issuers, obligations of the U.S. Government and its
agencies, commercial paper, and bank certificates of deposit; (b) shares of
other investment companies which have investment objectives consistent with
those of the Fund; (c) repurchase agreements involving any such securities; and
(d) other money market instruments. There is no limit on the extent to which the
Fund may take temporary defensive measures. In taking such measures, the Fund
may fail to achieve its investment objective.
FOREIGN INVESTMENTS. Vanguard Wellesley Income Fund may invest up to 20% of
its equity assets in foreign common stocks and securities convertible into
foreign stocks. The Fund may also invest in U.S. dollar denominated debt
securities issued by foreign governments, their agencies and instrumentalities,
supranational entities and companies located outside the U.S. without limit.
Investors should recognize that investing in foreign companies involves certain
special considerations which are not typically associated with investing in U.S.
companies. Among these risks are the following:
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Country Risk. As foreign companies are not generally subject to uniform
accounting, auditing and financial reporting standards and practices comparable
to those applicable to domestic companies, there may be less publicly available
information about certain foreign companies than about domestic companies.
Securities of some foreign companies are generally less liquid and more volatile
than securities of comparable domestic companies. There is generally less
government supervision and regulation of foreign stock exchanges, brokers and
listed companies than in the U.S. In addition, with respect to certain foreign
countries, there is the possibility of expropriation or confiscatory taxation,
political or social instability, or diplomatic developments which could affect
U.S. investments in those countries.
Although the Fund will endeavor to achieve the most favorable execution
costs in its portfolio transactions in foreign securities, fixed commissions on
many foreign stock exchanges are generally higher than negotiated commissions on
U.S. exchanges. In addition, it is expected that the expenses for custodial
arrangements of the Fund's foreign securities will be somewhat greater than the
expenses for the custodian arrangement for handling U.S. securities of equal
value.
Certain foreign governments levy withholding taxes against dividend and
interest income. Although in some countries a portion of these taxes is
recoverable, the non-recovered portion of foreign withholding taxes will reduce
the income the Fund receives from its foreign investments.
Currency Risk. Since the stocks of foreign companies are frequently
denominated in foreign currencies, and since the Fund may temporarily hold
uninvested reserves in bank deposits in foreign currencies, the Fund will be
affected favorably or unfavorably by changes in currency rates and in exchange
control regulations, and may incur costs in connection with conversions between
various currencies. The investment policies of the Fund permit it to enter into
forward foreign currency exchange contracts in order to hedge holdings and
commitments against changes in the level of future currency rates. Such
contracts involve an obligation to purchase or sell a specific currency at a
future date at a price set at the time of the contract.
FEDERAL TAX TREATMENT OF NON-U.S. TRANSACTIONS. Special rules govern the
Federal income tax treatment of certain transactions denominated in terms of a
currency other than the U.S. dollar or determined by reference to the value of
one or more currencies other than the U.S. dollar. The types of transactions
covered by the special rules include the following: (i) the acquisition of, or
becoming the obligor under, a bond or other debt instrument (including, to the
extent provided in Treasury regulations, preferred stock); (ii) the accruing of
certain trade receivables and payables; and (iii) the entering into or
acquisition of any forward contract, futures contract, option or similar
financial instrument if such instrument is not marked to market. The disposition
of a currency other than the U.S. dollar by a taxpayer whose functional currency
is the U.S. dollar is also treated as a transaction subject to the special
currency rules. However, foreign currency-related regulated futures contracts
and nonequity options are generally not subject to the special currency rules if
they are or would be treated as sold for their fair market value at year-end
under the marking-to-market rules applicable to other futures contracts unless
an election is made to have such currency rules apply. With respect to
transactions covered by the special rules, foreign currency gain or loss is
calculated separately from any gain or loss on the underlying transaction and is
normally taxable as ordinary income or loss. A taxpayer may elect to treat as
capital gain or loss foreign currency gain or loss arising from certain
identified forward contracts, futures contracts and options that are capital
assets in the hands of the taxpayer and which are not part of a straddle. The
Treasury Department issued regulations under which certain transactions subject
to the special currency rules that are part of a "section 988 hedging
transaction" (as defined in the Internal Revenue Code of 1986, as amended, and
the Treasury regulations) will be integrated and treated as a single transaction
or otherwise treated consistently for purposes of the Code. Any gain or loss
attributable to the foreign currency component of a transaction engaged in by a
fund which is not subject to the special currency rules (such as foreign equity
investments other than certain preferred stocks) will be treated as capital gain
or loss and will not be segregated from the gain or loss on the underlying
transaction. It is anticipated that some of the non-U.S. dollar-denominated
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investments and foreign currency contracts the Fund may make or enter into will
be subject to the special currency rules described above.
ILLIQUID SECURITIES. The Fund may invest up to 15% of its net assets in
illiquid securities. Illiquid securities are securities that may not be sold or
disposed of in the ordinary course of business within seven business days at
approximately the value at which they are being carried on the Fund's books.
The Fund may invest in restricted, privately placed securities that, under
securities laws, may be sold only to qualified institutional buyers. Because
these securities can be resold only to qualified institutional buyers or after
they have been held for a number of years, they may be considered illiquid
securities--meaning that they could be difficult for the Fund to convert to cash
if needed.
If a substantial market develops for a restricted security held by the
Fund, it will be treated as a liquid security, in accordance with procedures and
guidelines approved by the Fund's Board of Trustees. This generally includes
securities that are unregistered that can be sold to qualified institutional
buyers in accordance with Rule 144A under the Securities Act of 1933. While the
Fund's investment adviser determines the liquidity of restricted securities on a
daily basis, the Board oversees and retains ultimate responsibility for the
adviser's decisions. Several factors that the Board considers in monitoring
these decisions include the valuation of a security, the availability of
qualified institutional buyers, and the availability of information about the
security's issuer.
FUTURES CONTRACTS AND OPTIONS. The Fund may enter into futures contracts,
options, and options on futures contracts for the purpose of simulating full
investment and reducing transactions costs. Futures contracts provide for the
future sale by one party and purchase by another party of a specified amount of
a specific security at a specified future time and at a specified price. Futures
contracts which are standardized as to maturity date and underlying financial
instrument are traded on national futures exchanges. Futures exchanges and
trading are regulated under the Commodity Exchange Act by the Commodity Futures
Trading Commission (CFTC), a U.S. Government Agency. Assets committed to futures
contracts will be segregated to the extent required by law.
Although futures contracts by their terms call for actual delivery or
acceptance of the underlying securities, in most cases the contracts are closed
out before the settlement date without the making or taking of delivery. Closing
out an open futures position is done by taking an opposite position ("buying" a
contract which has previously been "sold," or "selling" a contract previously
purchased) in an identical contract to terminate the position. Brokerage
commissions are incurred when a futures contract is bought or sold.
Futures traders are required to make a good faith margin deposit in cash or
government securities with a broker or custodian to initiate and maintain open
positions in futures contracts. A margin deposit is intended to assure
completion of the contract (delivery or acceptance of the underlying security)
if it is not terminated prior to the specified delivery date. Minimal initial
margin requirements are established by the futures exchange and may be changed.
Brokers may establish deposit requirements which are higher than the exchange
minimums. Futures contracts are customarily purchased and sold on margin which
may range upward from less than 5% of the value of the contract being traded.
After a futures contract position is opened, the value of the contract is
marked to market daily. If the futures contract price changes to the extent that
the margin on deposit does not satisfy margin requirements, payment of
additional "variation" margin will be required. Conversely, change in the
contract value may reduce the required margin, resulting in a repayment of
excess margin to the contract holder. Variation margin payments are made to and
from the futures broker for as long as the contract remains open. The Fund
expects to earn interest income on its margin deposits.
Traders in futures contracts may be broadly classified as either "hedgers"
or "speculators." Hedgers use the futures markets primarily to offset
unfavorable changes in the value of securities otherwise held for investment
purposes or expected to be acquired by them. Speculators are less
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inclined to own the securities underlying the futures contracts which they
trade, and use futures contracts with the expectation of realizing profits from
fluctuations in the prices of underlying securities. The Fund intends to use
futures contracts only for bona fide hedging purposes.
Regulations of the CFTC applicable to the Fund require that all of its
futures transactions constitute bona fide hedging transactions except to the
extent that the aggregate initial margins and premiums required to establish any
non-hedging positions do not exceed five percent of the value of the Fund's
portfolio. The Fund will only sell futures contracts to protect securities it
owns against price declines or purchase contracts to protect against an increase
in the price of securities it intends to purchase. As evidence of this hedging
interest, the Fund expects that approximately 75% of its futures contract
purchases will be "completed," that is, equivalent amounts of related securities
will have been purchased or are being purchased by the Fund upon sale of open
futures contracts.
Although techniques other than the sale and purchase of futures contracts
could be used to control the Fund's exposure to market fluctuations, the use of
futures contracts may be a more effective means of hedging this exposure. While
the Fund will incur commission expenses in both opening and closing out futures
positions, these costs are lower than transaction costs incurred in the purchase
and sale of the underlying securities.
Restrictions on the Use of Futures Contracts The Fund will not enter into
futures contract transactions to the extent that, immediately thereafter, the
sum of its initial margin deposits on open contracts exceeds 5% of the market
value of the Fund's total assets. In addition, the Fund will not enter into
futures contracts to the extent that its outstanding obligations to purchase
securities under these contracts would exceed 20% of the Fund's total assets.
Risk Factors in Futures Transactions Positions in futures contracts may be
closed out only on an exchange which provides a secondary market for such
futures. However, there can be no assurance that a liquid secondary market will
exist for any particular futures contract at any specific time. Thus, it may not
be possible to close a futures position. In the event of adverse price
movements, the Fund would continue to be required to make daily cash payments to
maintain its required margin. In such situations, if the Fund has insufficient
cash, it may have to sell portfolio securities to meet daily margin requirements
at a time when it may be disadvantageous to do so. In addition, the Fund may be
required to make delivery of the instruments underlying futures contracts it
holds. The inability to close options and futures positions also could have an
adverse impact on the ability to effectively hedge it.
The Fund will minimize the risk that it will be unable to close out a
futures contract by only entering into futures which are traded on national
futures exchanges and for which there appears to be a liquid secondary market.
The risk of loss in trading futures contracts in some strategies can be
substantial, due both to the low margin deposits required, and the extremely
high degree of leverage involved in futures pricing. As a result, a relatively
small price movement in a futures contract may result in immediate and
substantial loss (as well as gain) to the investor. For example, if at the time
of purchase, 10% of the value of the futures contract is deposited as margin, a
subsequent 10% decrease in the value of the futures contract would result in a
total loss of the margin deposit, before any deduction for the transaction
costs, if the account were then closed out. A 15% decrease would result in a
loss equal to 150% of the original margin deposit if the contract were closed
out. Thus, a purchase or sale of a futures contract may result in losses in
excess of the amount invested in the contract. The Fund also bears the risk that
the adviser will incorrectly predict market trends. However, because the futures
strategies of the Fund are engaged in only for hedging purposes, the adviser
does not believe that the Fund will be subject to the risks of loss frequently
associated with futures transactions. The Fund would presumably have sustained
comparable losses if, instead of the futures contract, it had invested in the
underlying financial instrument and sold it after the decline.
Utilization of futures transactions by the Fund does involve the risk of
imperfect or no correlation where the securities underlying futures contracts
have different maturities than the
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portfolio securities being hedged. It is also possible that the Fund could both
lose money on futures contracts and also experience a decline in value of its
portfolio securities. There is also the risk of loss by the Fund of margin
deposits in the event of bankruptcy of a broker with whom the Fund has an open
position in a futures contract or related option. Additionally, investments in
futures contracts and options involve the risk that the adviser will incorrectly
predict stock market and interest rate trends.
Most futures exchanges limit the amount of fluctuation permitted in futures
contract prices during a single trading day. The daily limit establishes the
maximum amount that the price of a futures contract may vary either up or down
from the previous day's settlement price at the end of a trading session. Once
the daily limit has been reached in a particular type of contract, no trades may
be made on that day at a price beyond that limit. The daily limit governs only
price movement during a particular trading day and therefore does not limit
potential losses, because the limit may prevent the liquidation of unfavorable
positions. Futures contract prices have occasionally moved to the daily limit
for several consecutive trading days with little or no trading, thereby
preventing prompt liquidation of future positions and subjecting some futures
traders to substantial losses.
FEDERAL TAX TREATMENT OF FUTURES CONTRACTS. The Fund is required for
federal income tax purposes to recognize as income for each taxable year its net
unrealized gains and losses on certain futures contracts held as of the end of
the year as well as those actually realized during the year. In these cases, any
gain or loss recognized with respect to a futures contract is considered to be
60% long-term capital gain or loss and 40% short-term capital gain or loss,
without regard to the holding period of the contract. Gains and losses on
certain other futures contracts (primarily non-U.S. futures contracts) are not
recognized until the contracts are closed and are treated as long-term or
short-term depending on the holding period of the contract. Sales of futures
contracts which are intended to hedge against a change in the value of
securities held by the Fund may affect the holding period of such securities
and, consequently, the nature of the gain or loss on such securities upon
disposition. The Fund may be required to defer the recognition of losses on
futures contracts to the extent of any unrecognized gains on related positions
held by the Fund.
In order for the Fund to continue to qualify for federal income tax
treatment as a regulated investment company, at least 90% of its gross income
for a taxable year must be derived from qualifying income; i.e., dividends,
interest, income derived from loans of securities, gains from the sale of
securities or of foreign currencies, or other income derived with respect to the
Fund's business of investing in securities or currencies. It is anticipated that
any net gain recognized on futures contracts will be considered qualifying
income for purposes of the 90% requirement.
The Fund will distribute to shareholders annually any net capital gains
which have been recognized for federal income tax purposes on futures
transactions. Such distributions will be combined with distributions of capital
gains realized on the Fund's other investments and shareholders will be advised
on the nature of the distributions.
INVESTMENT POLICIES RELATING TO THE SALE OF INVESTOR SHARES OF VANGUARD
WELLESLEY INCOME FUND IN JAPAN
In connection with the offering of the Fund's Shares in Japan, the Fund has
undertaken to the Japanese Securities Dealers Association that the Fund may not:
1. Borrow money, except for temporary or emergency purposes in an amount not
exceeding 10% of the Fund's net assets;
2. Together with other mutual funds managed by The Vanguard Group, Inc.,
acquire more than 50% of the outstanding voting securities of any issuer;
3. Invest more than 15% of its net assets in illiquid securities (which
include securities restricted as to resale unless they are determined to be
readily marketable in accordance with procedures established by the Board
of Trustees); and
4. Sell securities short at any time in excess of its net asset value.
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If the undertaking is violated, the Fund will, promptly after discovery,
take such action as may be necessary to cause the violation to cease, which
shall be the only obligation of the Fund and the only remedy in respect of the
violation. This undertaking will remain in effect as long as (i) shares of the
Fund are qualified for offer or sale in Japan and (ii) the undertaking is
required by the "Standards of Selection of Foreign Investment Fund Securities"
established under the Rules of Foreign Securities Transactions by the Japanese
Securities Dealers Association.
FUNDAMENTAL INVESTMENT LIMITATIONS
The Fund is subject to the following fundamental investment limitations, which
cannot be changed in any material way without the approval of the holders of a
majority of the Fund's shares. For these purposes, a "majority" of shares means
shares representing the lesser of: (i) 67% or more of the votes cast to approve
a change, so long as shares representing more than 50% of the Fund's net asset
value are present or represented by proxy; or (ii) more than 50% of the Fund's
net asset value.
BORROWING. The Fund may not borrow money, except for temporary or emergency
purposes in an amount not exceeding 15% of the Fund's net assets. The Fund may
borrow money through banks, reverse repurchase agreements, or Vanguard's
interfund lending program only, and must comply with all applicable regulatory
conditions. The Fund may not make any additional investments whenever its
outstanding borrowings exceed 5% of net assets.
COMMODITIES. The Fund may not invest in commodities. The Fund may invest in
futures contracts on securities and indexes. The Fund may also invest in options
on futures and options on securities and indexes. No more than 5% of the Fund's
assets may be used as initial margin deposit and premium for futures contracts
and options, and the notional amount of futures contracts may not exceed 20% of
the Fund's assets at any time.
DIVERSIFICATION. With respect to 75% of its total assets, the Fund may not:
(i) purchase more than 10% of the outstanding voting securities of any one
issuer, or (ii) purchase securities of any issuer if, as a result, more than 5%
of the Fund's total assets would be invested in that issuer's securities. This
limitation does not apply to obligations of the United States Government, its
agencies, or instrumentalities.
ILLIQUID OR RESTRICTED SECURITIES. The Fund may not acquire any security
if, as a result, more than 15% of its net assets would be invested in securities
that are illiquid.
INDUSTRY CONCENTRATION. The Fund may not invest more than 25% of its total
assets in any one industry. Utility companies will be divided according to their
services; for example, gas, gas transmission, electric and gas, electric, and
telephone will each be considered a separate industry;
INVESTING FOR CONTROL. The Fund may not invest in a company for the purpose
of controlling its management.
INVESTMENT COMPANIES. The Fund may not invest in any other investment
company, except through a merger, consolidation or acquisition of assets, or to
the extent permitted by Section 12 of the 1940 Act. Investment companies whose
shares the Fund acquires pursuant to Section 12 must have investment objectives
and investment policies consistent with those of the Fund.
LOANS. The Fund may not lend money to any person except by purchasing
fixed-income securities that are publicly distributed or customarily purchased
by institutional investors or by entering into repurchase agreements, or by
lending its portfolio securities.
MARGIN. The Fund may not purchase securities on margin or sell securities
short, except as permitted by the Fund's investment policies relating to
commodities.
PLEDGING ASSETS. The Fund may not pledge, mortgage or hypothecate more than
15% of its net assets.
REAL ESTATE. The Fund may not invest directly in real estate, although it
may invest in securities of companies that deal in real estate, or interests
therein.
B-9
<PAGE>
SENIOR SECURITIES. The Fund may not issue senior securities, except in
compliance with the 1940 Act.
UNDERWRITING. The Fund may not engage in the business of underwriting
securities issued by other persons. The Fund will not be considered an
underwriter when disposing of its investment securities.
The investment limitations set forth above are considered at the time
investment securities are purchased. If a percentage restriction is adhered to
at the time the investment is made, a later increase in percentage resulting
from a change in the market value of assets will not constitute a violation of
such restriction.
None of these limitations prevents the Fund from participating in The
Vanguard Group, Inc. (Vanguard). As a member of The Vanguard Group of Investment
Companies, the Fund may own securities issued by Vanguard, make loans to
Vanguard, and contribute to Vanguard's costs or other financial requirements.
See "Management of the Fund" for more information.
SHARE PRICE
The Fund's share price, or "net asset value" per share, is calculated by
dividing the total assets of the Fund, less all liabilities, by the total number
of shares outstanding. The net asset value is determined as of the close of the
New York Stock Exchange, generally 4:00 p.m. Eastern time, on each day that the
Exchange is open for trading.
Portfolio securities for which market quotations are readily available
(includes those securities listed on national securities exchanges, as well as
those quoted on the NASDAQ Stock Market) will be valued at the last quoted sales
price on the day the valuation is made. Such securities which are not traded on
the valuation date are valued at the mean of the bid and ask prices. Price
information on exchange-listed securities is taken from the exchange where the
security is primarily traded. Securities may be valued on the basis of prices,
provided by a pricing service when such prices are believed to reflect the fair
market value of such securities.
Short term instruments (those with remaining maturities of 60 days or less)
may be valued at cost, plus or minus any amortized discount or premium, which
approximates market value.
Bonds and other fixed-income securities may be valued on the basis of
prices provided by a pricing service when such prices are believed to reflect
the fair market value of such securities. The prices provided by a pricing
service may be determined without regard to bid or last sale prices of each
security, but take into account institutional-size transactions in similar
groups of securities as well as any developments related to specific securities.
Foreign securities are valued at the last quoted sales price, according to
the broadest and most representative market, available at the time the Fund is
valued. If events which materially affect the value of the Fund's investments
occur after the close of the securities markets on which such securities are
primarily traded, those investments may be valued by such methods as the Board
of Trustees deems in good faith to reflect fair value.
In determining the Fund's net asset value per share, all assets and
liabilities initially expressed in foreign currencies will be converted into
U.S. dollars using the officially quoted daily exchange rates used by Morgan
Stanley Capital International in calculating various benchmarking indexes. This
officially quoted exchange rate may be determined prior to or after the close of
a particular securities market. If such quotations are not available, the rate
of exchange will be determined in accordance with policies established in good
faith by the Board of Trustees.
Other assets and securities for which no quotations are readily available
or which are restricted as to sale (or resale) are valued by such methods as the
Board of Trustees deems in good faith to reflect fair value.
The share price for the Fund can be found daily in the mutual fund listings
of most major newspapers under the heading of Vanguard Funds.
B-10
<PAGE>
PURCHASE OF SHARES
The Fund reserves the right in its sole discretion (i) to suspend the offerings
of its shares, (ii) to reject purchase or exchange purchase orders when in the
judgment of management such rejection is in the best interest of the Fund, and
(iii) to reduce or waive the minimum for any other restrictions on initial and
subsequent investments for certain fiduciary accounts or under circumstances
where certain economies can be achieved in sales of the Fund's shares.
TRADING SHARES THROUGH CHARLES SCHWAB
The Fund has authorized Charles Schwab & Co., Inc. (Schwab) to accept on its
behalf purchase and redemption orders under certain terms and conditions. Schwab
is also authorized to designate other intermediaries to accept purchase and
redemption orders on the Fund's behalf subject to those terms and conditions.
Under this arrangement, the Fund will be deemed to have received a purchase or
redemption order when Schwab or, if applicable, Schwab's authorized designee,
accepts the order in accordance with the Fund's instructions. Customer orders
that are properly transmitted to the Fund by Schwab, or if applicable, Schwab's
authorized designee, will be priced as follows:
Orders received by Schwab before 3 p.m. Eastern time on any business day,
will be sent to Vanguard that day and your share price will be based on the
Fund's net asset value calculated at the close of trading that day. Orders
received by Schwab after 3 p.m. Eastern time, will be sent to Vanguard on the
following business day and your share price will be based on the Fund's net
asset value calculated at the close of trading that day.
REDEMPTION OF SHARES
The Fund may suspend redemption privileges or postpone the date of payment (i)
during any period that the Exchange is closed, or trading on the Exchange is
restricted as determined by the Commission, (ii) during any period when an
emergency exists as defined by the Commission as a result of which it is not
reasonably practicable for the Fund to dispose of securities owned by it, or
fairly to determine the value of its assets, and (iii) for such other periods as
the Commission may permit.
The Fund has made an election with the Commission to pay in cash all
redemptions requested by any shareholder of record limited in amount during any
90-day period to the lesser of $250,000 or 1% of the net assets of the Fund at
the beginning of such period.
No charge is made by the Fund for redemptions. Shares redeemed may be worth
more or less than what was paid for them, depending on the market value of the
securities held by the Fund.
YIELD AND TOTAL RETURN
The yield of the Fund for the 30-day period ended December 31, 1999 was
5.73%. The average annual total return of the Fund for the one-, five-, and
ten-year periods ended December 31, 1999 was -4.14%, 12.69%, and 10.56%,
respectively.
SEC YIELD
Yield is the net annualized yield based on a specific 30-day (or one month)
period assuming semiannual compounding of income. Yield is calculated by
dividing the net investment income per share earned during the period by the
maximum offering price per share on the last day of the period, according to the
following formula:
B-11
<PAGE>
YIELD = 2[((A-B)CD+1)6 - 1]
Where:
a = dividends and interest earned during the period
b = expenses accrued for the period (net of reimbursements)
c = the average daily number of shares outstanding during
the period that were entitled to receive dividends
d = the maximum offering price per share on the last day of
the period
AVERAGE ANNUAL TOTAL RETURN
Average annual total return is the average annual compounded rate of return for
the periods of one year, five years, and ten years, all ended on the last day of
a recent month. Average annual total return quotations will reflect changes in
the price of the Fund's shares and assume that all dividends and capital gains
distributions during the respective periods were reinvested in Fund shares.
Average annual total return is calculated by finding the average annual
compounded rates of return of a hypothetical investment over such periods
according to the following formula (average annual total return is then
expressed as a percentage):
T = (ERV/P)1/N - 1
Where:
T = average annual total return
P = a hypothetical initial investment of $1,000
n = number of years
ERV =ending redeemable value: ERV is the value, at the end
of the applicable period, of a hypothetical $1,000
investment made at the beginning of the applicable
period
AVERAGE ANNUAL AFTER-TAX TOTAL RETURN QUOTATION
We calculate the Fund's average annual after-tax total return by finding the
average annual compounded rate of return over the 1-, 5-, and 10-year periods
that would equate the initial amount invested to the after-tax value, according
to the following formulas:
P (1+T) N = ATV
Where:
P = a hypothetical initial payment of $1,000
T = average annual after-tax total return
n = number of years
ATV = after-tax value at the end of the 1-, 5-, or 10-year
periods of a hypothetical $1,000 payment made at the beginning of
the time period, assuming no liquidation of the investment at the
end of the measurement periods.
Instructions.
1. Assume all distributions by the Fund are reinvested--less the taxes due on
such distributions--at the price on the reinvestment dates during the
period. Adjustments may be made for subsequent re-characterizations of
distributions.
2. Calculate the taxes due on distributions by the Fund by applying the
highest federal marginal tax rates to each component of the distributions
on the reinvestment date (e.g., ordinary income, short-term capital gain,
long-term capital gain, etc.). For periods after December 31, 1997, the
federal marginal tax rates used for the calculations are 39.6% for ordinary
income and short-term capital gains and 20% for long-term capital gains.
Note that the applicable tax rates may vary over the measurement period.
Assume no taxes are due on the portions of any
B-12
<PAGE>
distributions classified as exempt interest or non-taxable (i.e., return of
capital). Ignore any potential tax liabilities other than federal tax
liabilities (e.g., state and local taxes).
3. Include all recurring fees that are charged to all shareholder accounts.
For any account fees that vary with the size of the account, assume an
account size equal to the Fund's mean (or median) account size. Assume that
no additional taxes or tax credits result from any redemption of shares
required to pay such fees.
4. State the total return quotation to the nearest hundredth of one percent.
CUMULATIVE TOTAL RETURN
Cumulative total return is the cumulative rate of return on a hypothetical
initial investment of $1,000 for a specified period. Cumulative total
return quotations reflect changes in the price of the Fund's shares and
assume that all dividends and capital gains distributions during the period
were reinvested in Fund shares. Cumulative total return is calculated by
finding the cumulative rates of a return of a hypothetical investment over
such periods, according to the following formula (cumulative total return
is then expressed as a percentage):
C = (ERV/P) - 1
Where:
C = cumulative total return.
P = a hypothetical initial investment of $1,000.
ERV = ending redeemable value: ERV is the value, at the end
of the applicable period, of a hypothetical $1,000
investment made at the beginning of the applicable
period.
MANAGEMENT OF THE FUND
OFFICERS AND TRUSTEES
The officers of the Fund manage its day-to-day operations and are responsible to
the Fund's Board of Trustees. The Trustees set broad policies for the Fund and
choose its officers. The following is a list of the Trustees and officers of the
Fund and a statement of their present positions and principal occupations during
the past five years. As a group, the Fund's Trustees and officers own less than
1% of the outstanding shares of the Fund. Each Trustee also serves as a Director
of The Vanguard Group, Inc., and as a Trustee of each of the funds administered
by Vanguard. The mailing address of the Trustees and officers of the Fund is
Post Office Box 876, Valley Forge, PA 19482.
JOHN J. BRENNAN, (DOB: 7/29/1954)Chairman, Chief Executive Officer, and Trustee*
Chairman, Chief Executive Officer and Director of The Vanguard Group, Inc., and
Trustee of each of the investment companies in The Vanguard Group.
JOANN HEFFERNAN HEISEN, (DOB: 1/25/1950) Trustee
Vice President, Chief Information Officer, and member of the Executive Committee
of Johnson and Johnson (Pharmaceuticals/Consumer Products), Director of Johnson
& Johnson*MERCK Consumer Pharmaceuticals Co., The Medical Center at Princeton,
and Women's Research and Education Institute.
BRUCE K. MACLAURY, (DOB: 5/7/1931) Trustee
President Emeritus of The Brookings Institution (Independent Non-Partisan
Research Organization); Director of American Express Bank, Ltd., The St. Paul
Companies, Inc. (Insurance and Financial Services), and National Steel Corp.
BURTON G. MALKIEL, (DOB: 8/28/1932) Trustee
Chemical Bank Chairman's Professor of Economics, Princeton University; Director
of Prudential Insurance Co. of America, Banco Bilbao Argentaria, Gestion, BKF
Capital (Investment Management), The Jeffrey Co. (Holding Company), NeuVis, Inc.
(Software Co.), and Select Sector SPDR Trust (Exchange-Traded Mutual Fund).
B-13
<PAGE>
ALFRED M. RANKIN, JR., (DOB: 10/8/1941) Trustee
Chairman, President, Chief Executive Officer, and Director of NACCO Industries,
Inc. (Machinery/ Coal/Appliances); and Director of The BFGoodrich Co. (Aircraft
Systems/Manufacturing/Chemicals),.
JOHN C. SAWHILL, (DOB: 6/12/1936) Trustee
President and Chief Executive Officer of The Nature Conservancy (Non-Profit
Conservation Group); Director of Pacific Gas and Electric Co., Procter & Gamble
Co., NACCO Industries, Inc. (Machinery/ Coal/Appliances), and Newfield
Exploration Co. (Energy); formerly, Director and Senior Partner of McKinsey &
Co., and President of New York University.
JAMES O. WELCH, JR., (DOB: 5/13/1931) Trustee
Retired Chairman of Nabisco Brands, Inc. (Food Products); retired Vice Chairman
and Director of RJR Nabisco (Food and Tobacco Products); Director of TECO
Energy, Inc., and Kmart Corp.
J. LAWRENCE WILSON, (DOB: 3/2/1936) Trustee
Retired Chairman and CEO of Rohm & Haas Co. (Chemicals); Director of Cummins
Engine Co. (Diesel Engines), The Mead Corp. (Paper Products); and AmeriSource
Health Corp. (Pharmaceutical Distribution); and Trustee of Vanderbilt
University.
RAYMOND J. KLAPINSKY, (DOB:12/7/1938) Secretary*
Managing Director of The Vanguard Group, Inc.; Secretary of The Vanguard Group,
Inc. and of each of the investment companies in The Vanguard Group.
THOMAS J. HIGGINS, (DOB: 5/21/1957) Treasurer*
Principal of The Vanguard Group, Inc.; Treasurer of each of the investment
companies in The Vanguard Group.
ROBERT D. SNOWDEN, (DOB: 9/4/1961) Controller*
Principal of The Vanguard Group, Inc.; Controller of each of the investment
companies in The Vanguard Group.
*Officers of the Fund are "interested persons" as defined in the 1940 Act.
THE VANGUARD GROUP
Vanguard Wellesley Income Fund is a member of The Vanguard Group of Investment
Companies which consists of more than 100 funds. Through their jointly-owned
subsidiary, The Vanguard Group, Inc., the Fund, and the other funds in The
Vanguard Group obtain at cost virtually all of their corporate management,
administrative and distribution services. Vanguard also provides investment
advisory services on an at-cost basis to certain of the Vanguard funds.
Vanguard employs a supporting staff of management and administrative
personnel needed to provide the requisite services to the funds and also
furnishes the funds with necessary office space, furnishings and equipment. Each
fund pays its share of Vanguard's total expenses which are allocated among the
funds under methods approved by the Board of Trustees of each fund. In addition,
each fund bears its own direct expenses such as legal, auditing, and custodian
fees.
The Fund's officers are also officers and employees of Vanguard. No officer
or employee owns, or is permitted to own, any securities of any external adviser
for the funds.
Vanguard and the Fund's adviser have adopted Codes of Ethics designed to
prevent employees who may have access to nonpublic information about the trading
activities of the Fund (access persons) from profiting from that information.
The Codes permit access persons to invest in securities for their own accounts,
including securities that may be held by the Fund, but place substantive and
procedural restrictions on their trading activities. For example, the Codes
require that access persons receive advance approval for every securities trade
to ensure that there is no conflict with the trading activities of the Fund.
B-14
<PAGE>
Vanguard was established and operates under Amended and Restated Funds'
Service Agreement which was approved by the shareholders of each of the funds.
The amounts which each of the funds have invested are adjusted from time to time
in order to maintain the proportionate relationship between each fund's relative
net assets and its contribution to Vanguard's capital. The Amended and Restated
Funds' Service Agreement provides that each Vanguard fund may be called upon to
invest up to 0.40% of its current net assets in Vanguard as contributions to
Vanguard's capitalization. At December 31, 1999, Vanguard Wellesley Income Fund
had contributed capital of $1,500,000 to Vanguard, representing 0.02% of the
Fund's net assets and 1.5% of Vanguard's capitalization.
MANAGEMENT. Corporate management and administrative services include: (1)
executive staff; (2) accounting and financial; (3) legal and regulatory; (4)
shareholder account maintenance; (5) monitoring and control of custodian
relationships; (6) shareholder reporting; and (7) review and evaluation of
advisory and other services provided to the funds by third parties.
DISTRIBUTION. Vanguard Marketing Corporation, a wholly-owned subsidiary of
the Vanguard Group, Inc. provides all distribution and marketing activities for
the funds in the Group. The principal distribution expenses are for advertising,
promotional materials, and marketing personnel. Distribution services may also
include organizing and offering to the public, from time to time, one or more
new investment companies which will become members of Vanguard. The Trustees and
officers of Vanguard determine the amount to be spent annually on distribution
activities, the manner and amount to be spent on each fund, and whether to
organize new investment companies.
One half of the distribution expenses of a marketing and promotional nature
is allocated among the funds based upon relative net assets. The remaining one
half of those expenses is allocated among the funds based upon each fund's sales
for the preceding 24 months relative to the total sales of the funds as a group.
Provided, however, that no fund's aggregate quarterly rate of contribution for
distribution expenses of a marketing and promotional nature shall exceed 125% of
average distribution expense rate for the Vanguard, and that no fund shall incur
annual distribution expenses in excess of 20/100 of 1% of its average month-end
net assets.
During the fiscal years ended December 31, 1997, 1998, and 1999, the Fund
incurred the following approximate amounts of The Vanguard Group's management
(including transfer agency), distribution, and marketing expenses: $16,762,000,
$19,534,000, and $19,749,000, respectively.
INVESTMENT ADVISORY SERVICES
Vanguard also provides investment advisory services to several Vanguard
funds. These services are provided on an at-cost basis from a money management
staff employed directly by Vanguard. The compensation and other expenses of this
staff are paid by the funds utilizing these services.
TRUSTEE COMPENSATION
The same individuals serve as Trustees of all Vanguard funds (with two
exceptions, which are noted in the table appearing on page B-16), and each fund
pays a proportionate share of the Trustees' compensation. The funds employ their
officers on a shared basis, as well. However, officers are compensated by
Vanguard, not the funds.
INDEPENDENT TRUSTEES. The funds compensate their independent Trustees--that
is, the ones who are not also officers of the funds--in three ways:
. The independent Trustees receive an annual fee for their service to the
funds, which is subject to reduction based on absences from scheduled Board
meetings.
. The independent Trustees are reimbursed for the travel and other expenses
that they incur in attending Board meetings.
B-15
<PAGE>
. Upon retirement, the independent Trustees receive an aggregate annual fee
of $1,000 for each year served on the Board, up to fifteen years of
service. This annual fee is paid for ten years following retirement, or
until each Trustee's death.
"INTERESTED" TRUSTEE. Mr. Brennan serves as a Trustee, but is not paid in
this capacity. He is, however, paid in his role as officer of The Vanguard
Group, Inc.
COMPENSATION TABLE. The following table provides compensation details for
each of the Trustees. We list the amounts paid as compensation and accrued as
retirement benefits by the Fund for each Trustee. In addition, the table shows
the total amount of benefits that we expect each Trustee to receive from all
Vanguard funds upon retirement, and the total amount of compensation paid to
each Trustee by all Vanguard funds.
VANGUARD WELLESLEY INCOME FUND
TRUSTEES' COMPENSATION TABLE
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C>
PENSION OR TOTAL
AGGREGATE RETIREMENT COMPENSATION
COMPENSATION BENEFITS ACCRUED ESTIMATED ANNUAL FROM ALL VANGUARD
FROM THIS AS PART OF THIS BENEFITS UPON FUNDS PAID TO
NAMES OF TRUSTEES FUND(1) FUND'S EXPENSES(1) RETIREMENT TRUSTEES(2)
--------------------------------------------------------------------------------------------------
John C. Bogle(3) None None None None
John J. Brennan None None None None
JoAnn Heffernan Heisen $1,555 $86 $15,000 $80,000
Bruce K. MacLaury $1,609 $144 $12,000 $75,000
Burton G. Malkiel $1,566 $142 $15,000 $80,000
Alfred M. Rankin, Jr. $1,555 $104 $15,000 $80,000
John C. Sawhill $1,555 $131 $15,000 $80,000
James O. Welch, Jr. $1,555 $152 $15,000 $80,000
J. Lawrence Wilson $1,555 $110 $15,000 $80,000
</TABLE>
---------
(1) The amounts shown in this column are based on the Fund's fiscal year ended
December 31, 1999.
(2) The amounts reported in this column reflect the total compensation paid to
each Trustee for his or her service as Trustee of 103 Vanguard funds (102
in the case of Mr. Malkiel; 93 in the case of Mr. MacLaury) for the 1999
calendar year.
(3) Mr. Bogle retired from the Fund's Board on December 31, 1999.
INVESTMENT ADVISORY SERVICES
The Fund employs Wellington Management Company, LLP (Wellington Management)
under an investment advisory agreement to manage the investment and reinvestment
of Vanguard Wellesley Income Fund's assets and to continuously review,
supervise, and administer the Fund's investment program. Wellington Management
is a professional investment counseling firm which provides investment services
to investment companies, other institutions and individuals. Among the clients
of Wellington Management are more than 15 Vanguard funds. Wellington Management
and its predecessor organizations have provided investment advisory services to
investment companies since 1928 and to investment counseling clients since 1960.
Wellington Management discharges its responsibilities subject to the control of
the officers and Trustees of the Fund. Wellington Management is a Massachusetts
limited liability partnership whose managing partners are Laurie A. Gabriel,
Duncan M. McFarland, and John R. Ryan.
B-16
<PAGE>
The Fund pays Wellington Management an advisory fee at the end of each
fiscal quarter, calculated by applying a quarterly rate, based on the following
annual percentage rates, to the Fund's average month-end net assets for the
quarter:
NET ASSETS ANNUAL RATE
---------- ----------
First $1 billion........ .100%
Next $2 billion......... .050%
Next $7 billion......... .040%
Over $10 billion........ .030%
The quarterly payment to Wellington Management may be increased or decreased
by applying an adjustment reflecting the investment performance of the Fund
relative to the investment performance of a "Composite Index," 65% of which will
comprise the Lehman Brothers Corporate A or Better Bond Index (the "Bond Index")
and 35% of which will comprise a "Blended Equity Composite," (75% Standard &
Poor's/BARRA Value Index, 12.5% Standard & Poor's Utilities Index, and 12.5%
Standard & Poor's Telephone Index).
The following table sets forth the adjustment:
CUMULATIVE 36-MONTH PERFORMANCE PERFORMANCE FEE
VERSUS THE COMPOSITE INDEX ADJUSTMENT*
-------------------------- -----------------
Less than -3%................. -0.20 x Basic Fee
Between -1.5% and -3%......... -0.10 x Basic Fee
Between -1.5% and 1.5%........ 0.00 x Basic Fee
Between +1.5% and +3%......... +0.10 x Basic Fee
More than +3%................. +0.20 x Basic Fee
*For purposes of this calculation, the Basic Fee is calculated by applying the
quarterly rate against average assets over the same time period which the
performance is measured.
The Composite Index will not become fully operable as the sole performance
index for purposes of calculating the adjustment until the quarter ending March
31, 2003. Until that date, the adjustment will be determined by linking the
investment performance of the Composite Index and that of the "Prior Benchmark,"
35% of which will comprise the Blended Equity Composite and 65% of which will
comprise the Lehman Brothers Long-Term Corporate AA or Better Bond Index (the
"Prior Bond Index") as follows:
1. QUARTER ENDING JUNE 30, 2000. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the eleven
quarters ended March 31, 2000, with that of the Composite Index for the quarter
ending June 30, 2000.
2. QUARTER ENDING SEPTEMBER 30, 2000. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the ten quarters
ended March 31, 2000, with that of the Composite Index for the two quarters
ending September 30, 2000.
3. QUARTER ENDING DECEMBER 31, 2000. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the nine quarters
ended March 31, 2000, with that of the Composite Index for the three quarters
ending December 31, 2000.
4. QUARTER ENDING MARCH 31, 2001. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the eight quarters
ended March 31, 2000, with that of the Composite Index for the four quarters
ending March 31, 2001.
5. QUARTER ENDING JUNE 30, 2001. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the seven quarters
ended March 31, 2000, with that of the Composite Index for the five quarters
ending June 30, 2001.
B-17
<PAGE>
6. QUARTER ENDING SEPTEMBER 30, 2001. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the six quarters
ended March 31, 2000, with that of the Composite Index for the six quarters
ending September 30, 2001.
7. QUARTER ENDING DECEMBER 31, 2001. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the five quarters
ended March 31, 2000, with that of the Composite Index for the seven quarters
ending December 31, 2001.
8. QUARTER ENDING MARCH 31, 2002. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the four quarters
ended March 31, 2000, with that of the Composite Index for the eight quarters
ending March 31, 2002.
9. QUARTER ENDING JUNE 30, 2002. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the three quarters
ended March 31, 2000, with that of the Composite Index for the nine quarters
ending June 30, 2002.
10. QUARTER ENDING SEPTEMBER 30, 2002. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the two quarters
ended March 31, 2000, with that of the Composite Index for the ten quarters
ending September 30, 2002.
11. QUARTER ENDING DECEMBER 31, 2002. The adjustment will be determined by
linking the investment performance of the Prior Benchmark for the one quarter
ended March 31, 2000, with that of the Composite Index for the eleven quarters
ending December 31, 2002.
12. QUARTER ENDING MARCH 31, 2003. The Composite Index is fully operable.
The investment performance of the Fund for any period, expressed as a
percentage of the Fund's net asset value per share at the beginning of the
period, shall be the sum of (i) the change in the Fund's net asset value per
share during the period; (ii) the value of the Fund's cash distributions per
share having an ex-dividend date occurring within the period, and (iii) the per
share amount of capital gains taxes paid or accrued during such period by the
Fund for undistributed realized long-term capital gains.
COMPOSITE INDEX. The investment record of the Composite Index for any
period, expressed as a percentage of the Composite Index at the beginning of
such period, will be the sum of: (i) the change in the level of the Composite
Index during the period; (ii) the value of the interest accrued or paid on the
bonds included in the Composite Index, assuming the reinvestment of such
interest on a monthly basis. Computations of the two components of the Composite
Index will be made at the beginning of each quarter, based on the allocation set
forth in this Agreement.
BOND INDEX. The investment record of the Bond Index for the period,
expressed as a percentage of the Bond Index at the beginning of such period,
will be the sum of: (i) the change in the level of the Composite Index during
the period; (ii) the value of the interest accrued or paid on the bonds included
in the Composite Index, assuming the reinvestment of such interest on a monthly
basis.
BLENDED EQUITY COMPOSITE. The investment record of the Blended Equity
Composite for any period, expressed as a weighted percentage of the respective
indexes at the beginning of such period, will be the sum of: (i) the change in
the level of the indexes during the period; (ii) the value, computed
consistently with the applicable indexes, of cash distributions having an
ex-dividend date occurring within the period made by companies whose securities
comprise the applicable indexes.
PRIOR BENCHMARK. The investment record of the Prior Benchmark for any
period will be computed in the same manner as that of the Composite Index;
provided, however, that the Prior Bond Index will be substituted for the Bond
Index.
During the fiscal years ended December 31, 1997, 1998, and 1999, the Fund
incurred investment advisory fees of approximately $3,646,000 before an increase
of $718,000 based on performance, $4,026,000 before an increase of $648,000
based on performance, and $3,763,000 before a decrease of $196,000 based on
performance, respectively.
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The present agreement is renewable for successive one-year periods, only if
such renewal is specifically approved at least annually by a vote of the Fund's
Board of Trustees, including the affirmative votes of a majority of the Trustees
who are not parties to the contract or "interested persons" (as defined in the
1940 Act) of any such party, cast in person at a meeting called for the purpose
of considering such approval. The agreement is automatically terminated if
assigned, and may be terminated without penalty at any time (1) either by vote
of the Board of Trustees of the Fund or by vote of its outstanding voting
securities on 60 days' written notice to the adviser, or (2) by the adviser upon
90 days' written notice to the Fund.
PORTFOLIO TRANSACTIONS
The investment advisory agreement authorizes Wellington Management (with the
approval of the Fund's Board of Trustees) to select the brokers or dealers that
will execute the purchases and sales of portfolio securities for the Fund and
directs Wellington Management to use its best efforts to obtain the best
available price and most favorable execution as to all transactions for the
Fund. Wellington Management has undertaken to execute each investment
transaction at a price and commission which provides the most favorable total
cost or proceeds reasonably obtainable under the circumstances.
In placing portfolio transactions, Wellington Management will use its best
judgment to choose the broker most capable of providing the brokerage services
necessary to obtain the best available price and the most favorable execution.
The full range and quality of brokerage services available will be considered in
making these determinations. In those instances where it is reasonably
determined that more than one broker can offer the brokerage services needed to
obtain the best available price and the most favorable execution, consideration
may be given to those brokers which supply investment research and statistical
information and provide other services in addition to execution services to the
Fund and/or Wellington Management. Wellington Management considers such
information useful in the performance of its obligations under the agreement but
is unable to determine the amount by which such services may reduce its
expenses.
The investment advisory agreement also incorporates the concepts of Section
28(e) of the Securities Exchange Act of 1934 by providing that, subject to the
approval of the Fund's Board of Trustees, Wellington Management may cause the
Fund to pay a broker-dealer which furnishes brokerage and research services a
higher commission than that which might be charged by another broker-dealer for
effecting the same transaction; provided that such commission is deemed
reasonable in terms of either that particular transaction or the overall
responsibilities of Wellington Management to the Fund.
Currently, it is the Fund's policy that Wellington Management may at times
pay higher commissions in recognition of brokerage services felt necessary for
the achievement of better execution of certain securities transactions that
otherwise might not be available. Wellington Management will only pay such
higher commissions if it believes this to be in the best interest of the Fund.
Some brokers or dealers who may receive such higher commissions in recognition
of brokerage services related to execution of securities transactions are also
providers of research information to Wellington Management and/or the Fund.
However, Wellington Management has informed the Fund that it generally will not
pay higher commission rates specifically for the purpose of obtaining research
services.
Since the Fund does not market its shares through intermediary brokers or
dealers, it is not the Fund's practice to allocate brokerage or principal
business on the basis of sales of its shares which may be executed through such
firms. However, the Fund may place portfolio orders with qualified
broker-dealers who recommend the Fund to other clients, or who act as agent in
the purchase of the Fund's shares for their clients, and may, when a number of
brokers and dealers can provide comparable best price and execution on a
particular transaction, consider the sale of Fund shares by a broker or dealer
in selecting among qualified broker-dealers.
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During the fiscal years ended December 31, 1997, 1998, and 1999, the Fund
paid approximately $2,672,000, $1,984,000, and $2,600,848 in brokerage
commissions, respectively.
Some securities considered for investment by the Fund may also be
appropriate for other Vanguard Funds and/or other clients served by Wellington
Management. If purchases or sales of securities consistent with the investment
policies of the Fund, the other Vanguard funds, and/or one or more of these
other clients serviced by Wellington Management are considered at or about the
same time, transactions in such securities will be allocated among the several
Funds and clients in a manner deemed equitable by Wellington Management.
Although there will be no specified formula for allocating such transactions,
the allocation methods used, and the results of such allocations, will be
subject to periodic review by the Fund's Board of Trustees.
COMPARATIVE INDEXES
Each of the investment company members of The Vanguard Group, including Vanguard
Wellesley Income Fund, may, from time to time, use one or more of the following
unmanaged indexes for comparative performance purposes.
STANDARD & POOR'S 500 COMPOSITE STOCK PRICE INDEX--includes stocks selected by
Standard & Poor's Index Committee to include leading companies in leading
industries and to reflect the U.S. stock market.
STANDARD & POOR'S MIDCAP 400 INDEX--is composed of 400 medium sized domestic
stocks.
STANDARD & POOR'S SMALLCAP 600/BARRA VALUE INDEX--contains stocks of the S&P
SmallCap 600 Index which have a lower than average price-to-book ratio.
STANDARD & POOR'S SMALLCAP 600/BARRA GROWTH INDEX--contains stocks of the S&P
SmallCap 600 Index which have a higher than average price-to-book ratio.
RUSSELL 1000 VALUE INDEX--consists of the stocks in the Russell 1000 Index
(comprising the 1,000 largest U.S.-based companies measured by total market
capitalization) with the lowest price-to-book ratios, comprising 50% of the
market capitalization of the Russell 1000.
WILSHIRE 5000 TOTAL MARKET INDEX--consists of more than 7,000 common equity
securities, covering all stocks in the U.S. for which daily pricing is
available.
WILSHIRE 4500 COMPLETION INDEX--consists of all stocks in the Wilshire 5000
except for the 500 stocks in the Standard and Poor's 500 Index.
MORGAN STANLEY CAPITAL INTERNATIONAL EAFE INDEX--is an arithmetic, market
value-weighted average of the performance of over 900 securities listed on the
stock exchanges of countries in Europe, Australia, Asia and the Far East.
GOLDMAN SACHS 100 CONVERTIBLE BOND INDEX--currently includes 71 bonds and 29
preferreds. The original list of names was generated by screening for
convertible issues of $100 million or greater in market capitalization. The
index is priced monthly.
SALOMON BROTHERS GNMA INDEX--includes pools of mortgages originated by private
lenders and guaranteed by the mortgage pools of the Government National Mortgage
Association.
SALOMON BROTHERS HIGH-GRADE CORPORATE BOND INDEX--consists of publicly issued,
non-convertible corporate bonds rated Aa or Aaa. It is a value-weighted, total
return index, including approximately 800 issues with maturities of 12 years or
greater.
LEHMAN BROTHERS LONG-TERM TREASURY BOND INDEX--is a market weighted index that
contains individually priced U.S. Treasury securities with maturities of 10
years or greater.
MERRILL LYNCH CORPORATE & GOVERNMENT BOND INDEX--consists of over 4,500 U.S.
Treasury, agency and investment grade corporate bonds.
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LEHMAN BROTHERS CORPORATE (BAA) BOND INDEX--consists of all publicly offered
fixed-rate, nonconvertible domestic corporate bonds rated Baa by Moody's, with a
maturity longer than one year and with more than $100 million outstanding. This
index includes over 1,500 issues.
LEHMAN BROTHERS LONG-TERM CORPORATE BOND INDEX--is a subset of the Lehman
Brothers Corporate Bond Index covering all corporate, publicly issued
fixed-rate, nonconvertible US debt issues rated at least Baa, with at least $100
million principal outstanding and maturity greater than 10 years.
BOND BUYER MUNICIPAL BOND INDEX--is a yield index on current coupon high-grade
general obligation municipal bonds.
MERRILL LYNCH DRD-ELIGIBLE INDEX--includes preferred stock issues which are
eligible for the corporate dividends-received-deduction.
NASDAQ INDUSTRIAL INDEX--is composed of more than 3,000 industrial issues. It is
a value-weighted index calculated on price change only and does not include
income.
COMPOSITE INDEX--70% Standard & Poor's 500 Index and 30% NASDAQ Industrial
Index.
COMPOSITE INDEX--65% Standard & Poor's 500 Index and 35% Lehman Brothers
Corporate A or Better Bond Index.
COMPOSITE INDEX--65% Lehman Brothers Corporate A or Better Bond Index and a 35%
weighting in a blended equity composite (75% Standard & Poor's/BARRA Value
Index, 12.5% Standard & Poor's Utilities Index and 12.5% Standard & Poor's
Telephone Index).
LEHMAN BROTHERS LONG-TERM CORPORATE AA OR BETTER BOND INDEX--consists of all
publicly issued, fixed rate, nonconvertible investment grade,
dollar-denominated, SEC-registered corporate debt rated AA or AAA.
LEHMAN BROTHERS CORPORATE A OR BETTER BOND INDEX--consists of all publicly
issued, investment grade corporate bonds rated A or better, of all maturity
levels.
RUSSELL 2000 STOCK INDEX--consists of the smallest 2,000 stocks within the
Russell 3000; a widely-used benchmark for small capitalization common stocks.
LEHMAN BROTHERS AGGREGATE BOND INDEX--is a market-weighted index that contains
individually priced U.S.Treasury, agency, corporate, and mortgage pass-through
securities corporate rated BBB- or better. The Index has a market value of over
$5 trillion.
LEHMAN BROTHERS MUTUAL FUND SHORT (1-5) GOVERNMENT/CORPORATE INDEX--is a
market-weighted index that contains individually priced U.S. Treasury, agency,
and corporate investment grade bonds rated BBB- or better with maturities
between 1 and 5 years. The index has a market value of over $1.6 trillion.
LEHMAN BROTHERS MUTUAL FUND INTERMEDIATE (5-10) GOVERNMENT/CORPORATE INDEX--is a
market-weighted index that contains individually priced U.S. Treasury, agency,
and corporate securities rated BBB- or better with maturities between 5 and 10
years. The index has a market value of over $800 billion.
LEHMAN BROTHERS LONG (10+) GOVERNMENT/CORPORATE INDEX--is a market-weighted
index that contains individually priced U.S. Treasury, agency, and corporate
securities rated BBB- or better with maturities greater than 10 years. The index
has a market value of over $1.1 trillion.
LIPPER BALANCED FUND AVERAGE--an industry benchmark of average balanced funds
with similar investment objectives and policies, as measured by Lipper Inc.
LIPPER NON-GOVERNMENT MONEY MARKET FUND AVERAGE--an industry benchmark of
average non-government money market funds with similar investment objectives and
policies, as measured by Lipper Inc.
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LIPPER GOVERNMENT MONEY MARKET FUND AVERAGE--an industry benchmark of average
government money market funds with similar investment objectives and policies,
as measured by Lipper Inc.
LIPPER SMALL COMPANY GROWTH FUND AVERAGE--the average performance of small
company growth funds as defined by Lipper Inc. Lipper defines a small company
growth fund as a fund that by prospectus or portfolio practice, limits its
investments to companies on the basis of the size of the company. From time to
time, Vanguard may advertise using the average performance and/or the average
expense ratio of the small company growth funds. (This fund category was first
established in 1982. For years prior to 1982, the results of the Lipper Small
Company Growth category were estimated using the returns of the Funds that
constituted the Group at its inception.)
LIPPER GENERAL EQUITY FUND AVERAGE--an industry benchmark of average general
equity funds with similar investment objectives and policies, as measured by
Lipper Inc.
LIPPER FIXED-INCOME FUND AVERAGE--an industry benchmark of average fixed-income
funds with similar investment objectives and policies, as measured by Lipper
Inc.
RUSSELL 3000 INDEX--consists of approximately the 3,000 largest stocks of
U.S.-domiciled companies commonly traded on the New York and American Stock
Exchanges or the NASDAQ over-the-counter market, accounting for over 90% of the
market value of publicly traded Stocks in the U.S.
FINANCIAL STATEMENTS
The Fund's Financial Statements for the year ended December 31, 1999, including
the financial highlights for each of the five years in the period ended December
31, 1999, appearing in the Vanguard Wellesley Income Fund's 1999 Annual Report
to Shareholders, and the report thereon of PricewaterhouseCoopers LLP,
independent accountants, also appearing therein, are incorporated by reference
in this Statement of Additional Information. For a more complete discussion of
the performance, please see the Fund's Annual Report to Shareholders, which may
be obtained without charge.
APPENDIX--DESCRIPTION OF SECURITIES AND RATINGS
The Fund will invest in investment grade bonds (i.e. those rated at least Baa by
Moody's Investors Service, Inc. or those rated BBB by Standard & Poor's
Corporation). In the event that a bond held by the Fund is downgraded, the
adviser may continue to hold such bond.
The following are excerpts from Moody's Investors Service, Inc. description
of its four highest preferred bond ratings:
AAA--judged to be the best quality by all standards; AA--together with the Aaa
group, comprise what are generally known as high grade bonds; A--possess many
favorable investment attributes and are to be considered as "upper medium grade
obligations"; BAA--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.
Moody's also supplies numerical indicators 1, 2, and 3 to rating
categories. The modifier 1 indicates that the security is in the higher end of
its rating category; the modifier 2 indicates a mid-range ranking; and 3
indicates a ranking toward the lower end of the category.
The following are excerpts from Standard & Poor's Corporation description
of its four highest stock ratings:
AAA--highest grade obligations. Capacity to pay interest and repay principal is
extremely strong; AA--also qualify as high grade obligations, a very strong
capacity to pay interest and repay
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principal and differs from AAA issues only in small degree; A--regarded as upper
medium grade. They have a strong capacity to pay interest and repay principal
although somewhat susceptible to the adverse effects of changes in circumstances
and economic conditions than debt in higher rated categories; BBB--regarded as
having an adequate capacity to pay interest and repay principal. Whereas they
normally exhibit 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. This group is the lowest which qualifies for commercial bank
investment.
Standard & Poor's applies indicators "+", no character and "-" to its
rating categories. The indicators show relative standing within the major rating
categories.
SAI027-WELLESLEY INCOME
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