N-30D 1 convertiblesec.txt CONVERTIBLE SECURITIES SEMI-ANNUAL REPORT VANGUARD(R) CONVERTIBLE SECURITIES FUND Semiannual Report May 31, 2001 [PHOTO OF COMPASS/SHIP] [THE VANGUARD GROUP(R) LOGO] SOME LESSONS FROM THE MARKETS Although the past year has been a trying period for many investors, it reinforced some investment truths worth keeping in mind as you build and maintain your portfolio. These include: * THINGS CHANGE. It's difficult--bordering on impossible--to consistently or precisely predict when the financial markets will turn up or down, when the economy will accelerate or slow, and which investments will lead or lag. Don't risk your hard-earned money by betting on such forecasts. * DIVERSIFICATION MATTERS. If you build and maintain a portfolio that includes different asset classes--as well as types of securities within asset classes--you give yourself a valuable buffer against severe damage from any one market segment. True, your diversified portfolio will never top the short-term performance charts. But a balanced investment approach will help you to meet your financial goals without taking undue risks. * PERSPECTIVE IS PARAMOUNT. Market declines are always painful. Yet they're inevitable if you seek the long-term rewards of investing. If you keep your focus on your long-term goals, you'll find periodic downturns much easier to endure, and you'll avoid making emotion-driven mistakes. SUMMARY * Vanguard Convertible Securities Fund returned 7.6% during the six months ended May 31, 2001, outpacing the results of both its average peer and its index benchmark. * Small-capitalization stocks--to which the fortunes of many convertible securities are tied--delivered excellent returns during the period. * Technology and telecommunications companies, which are heavy issuers of convertibles, continued to struggle amid slowing demand. CONTENTS 1 Letter from the Chairman 5 Report from the Adviser 8 Fund Profile 9 Glossary of Investment Terms 11 Performance Summary 12 Financial Statements LETTER from the Chairman Fellow Shareholder, VANGUARD CONVERTIBLE SECURITIES FUND provided an excellent total return of 7.6% during the fiscal half-year ended May 31, 2001--a period that exemplified the benefits of a balanced approach to investing. Bonds and value stocks provided refuge as the overall stock market continued to fall from its peak in early 2000. -------------------------------------------------------- TOTAL RETURNS SIX MONTHS ENDED MAY 31, 2001 -------------------------------------------------------- Vanguard Convertible Securities Fund 7.6% Average Convertible Securities Fund* 2.0 CS First Boston Convertibles Index 4.1 -------------------------------------------------------- *Derived from data provided by Lipper Inc. The table at right presents the six-month total returns (capital change plus reinvested dividends) for your fund, its average peer mutual fund, and its unmanaged benchmark, the Credit Suisse First Boston Convertible Securities Index. The fund's return is based on an increase in net asset value from $12.68 per share on November 30, 2000, to $12.84 per share on May 31, 2001, and is adjusted for dividends totaling $0.27 per share paid from net investment income and a distribution of $0.51 per share paid from net realized capital gains. FINANCIAL MARKETS IN REVIEW During the six months ended May 31, the U.S. economy was marked by two opposing trends: strength among consumers and weakness in the industrial sectors. Housing starts and sales were strong, and consumer spending remained healthy. Unemployment edged up-- in May 4.4% of the labor force was unemployed--but consumers stayed relatively calm. Indeed, a survey of consumer confidence showed improved sentiment in May, although the confidence MARKET BAROMETER TOTAL RETURNS PERIOSS ENDED MAY 31, 2001 SIX ONE FIVE MONTHS YEAR YEARS* ---------------------------------------------------------------------------- STOCKS ------ S&P 500 Index (Large-caps) -3.9% -10.6% 15.1% Russell 2000 Index (Small-caps) 12.2 5.7 8.0 Wilshire 5000 Index (Entire market) -2.5 -10.1 13.3 MSCI EAFE Index (International) -7.6 -16.9 4.2 ---------------------------------------------------------------------------- BONDS ----- Lehman Aggregate Bond Index (Entire market) 5.1% 13.1% 7.7% Lehman 10 Year Municipal Bond Index 4.6 11.8 6.7 Salomon Smith Barney 3-Month U.S. Treasury Bill Index 2.7 5.8 5.2 ============================================================================ CPI --- Consumer Price Index 2.1% 3.6% 2.6% ---------------------------------------------------------------------------- *Annualized. 1 level was well below the January 2000 high. The industrial economy fared worse. Businesses trimmed spending on capital equipment, with especially sharp cutbacks in outlays for computers and software. Industrial production declined throughout the half-year. Manufacturing activity cooled, and slowing sales within the industrial sector left substantial inventory on warehouse shelves. Overall, a strong consumer economy and a weak industrial economy added up to modest growth in the period. In the first quarter of 2001, inflation-adjusted gross domestic product, the estimated value of the nation's output of goods and services, increased at a 1.2% annual rate, far below the 4.8% pace during the same period in 2000. The Federal Reserve Board's Open Market Committee responded to the mixed economic picture with five reductions in its target for short-term interest rates. The first cut came in January and the most recent on May 15. In total, the FOMC sliced 250 basis points (2.5 percentage points) from short-term rates in an effort to stimulate capital spending and sustain consumers' upbeat mood. ---------------------- THE FEDERAL RESERVE BOARD SLICED 2.5 PERCENTAGE POINTS FROM SHORT-TERM INTEREST RATES TO STIMULATE THE ECONOMY. ---------------------- The U.S. stock market's course reflected the uncertainty in the broad economy. After a swift fall early in the six months, stocks rallied in April and May. Continued weakness in technology stocks kept the broad stock market in negative territory, but small-capitalization stocks and value stocks--those issues with low prices relative to fundamental measures such as earnings and book value--thrived. Bonds turned in good results during the period. The prices of bonds with maturities of less than 5 years enjoyed the biggest gains, as short-term yields declined in step with the FOMC's rate cuts. (Bond prices move in the opposite direction from their yields.) The story was different for long-term bonds. Yields rose, and prices declined, heightening the difference between the cost of short-term and long-term borrowing. At the end of May, the gap between the yield of the 30-year U.S. Treasury bond and that of the 3-year Treasury note stood at 116 basis points (1.16 percentage points), up from just 3 basis points six months earlier. ---------------- MOST BONDS PERFORMED WELL. CORPORATE ISSUES LED THE WAY. ---------------- Corporate bonds outperformed their Treasury counterparts (with the exception of inflation-indexed notes) across all maturities during the period. The riskiest credits ("high-yield" bonds) turned in the best results, with the Lehman Brothers High Yield Bond Index advancing 9.0%. 2 PERFORMANCE REVIEW The Convertible Securities Fund's six-month return of 7.6% was well above those of its average competitor and its benchmark index. With the economy slowing--and with estimates of corporate earnings being steadily trimmed--investors favored stocks that had relatively low valuations. Small-cap issues benefited from this price sensitivity. As the period began, the small-cap Russell 2000 Index had a combined price/earnings ratio of 20.7. (This means investors were paying $20.70 for each $1 in estimated earnings.) Large-cap stocks, as measured by the Standard & Poor's 500 Index, were more richly valued--they had an average price/earnings ratio of 25.2. By May 31, the earnings multiple on small-cap stocks had climbed to 27.1, surpassing the multiple on large-caps. This rising valuation helped the Russell 2000 Index to post a 12.2% total return during the period. The strength of small-caps is significant, because many of your fund's holdings are convertible into common stocks of that size, making their prices sensitive to the movement of equity prices in that sector. The Convertible Securities Fund also benefited from the solid performance of short-term corporate bonds, which returned 6.2% during the six months, as measured by the Lehman 1-5 Year U.S. Credit Index. Our investment adviser, Oaktree Capital Management, had three-quarters of the fund's assets invested in convertible corporate bonds at the start of the period. With an average weighted maturity of about 5 years, these holdings were well-positioned to benefit from the FOMC's rate cuts. Your fund performed well relative to the average convertible securities fund and the CS First Boston Convertibles Index because the adviser maintained its discipline, holding securities with a mix of equity and fixed income characteristics. Convertible bonds and preferred stocks that appreciated the most and began to trade like the underlying common stocks were sold. This policy led the fund to underperform its average peer in fiscal 1999, when securities issued by technology, media, and telecommunications companies were riding high. The approach, however, boosted performance in the first half of fiscal 2001 because investors continued to reconsider the lofty values they once placed on such securities. --------------------- YOUR FUND PERFORMED WELL RELATED TO COMPETITIVE STANDARDS BECAUSE THE ADVISER MAINTAINED ITS DISCIPLINE. --------------------- The fund's yield declined from 4.1% on November 30, 2000, to 3.7% on May 31. IN SUMMARY The slumping stock market in the new millennium so far stands in sharp contrast to the booming bull market of the 1990s. Investors who overemphasized 3 the "hot" market sectors and underestimated the importance of diversification were the hardest-hit victims of the market plunge. Now, we fear that some investors may overreact to the downturn in stocks or chase this year's top- performing sectors. Our advice--in both rising and falling markets--is the same: Tune out the noise and concentrate on your investment plan. It should consist of stock, bond, and money market mutual funds--convertible securities can also play a useful role--mixed in proportions that suit your goals, time horizon, and risk tolerance. Then, once you have such a plan, stay the course. Thank you for entrusting your hard-earned dollars to us. /s/ JOHN J. BRENNAN Chairman and Chief Executive Officer June 19, 2001 [PHOTO OF JOHN J. BRENNAN] JOHN J. BRENNAN CHAIRMAN AND CHIEF EXECUTIVE OFFICER 4 REPORT from the Adviser OAKTREE CAPITAL MANAGEMENT, LLC The performance of vanguard convertible securities fund in the first half of fiscal 2001 was rewarding. In a highly volatile investment environment, the fund delivered a total return of 7.6%--well ahead of the results for its primary benchmark (the CS First Boston Convertibles Index) and the average convertibles fund. The fund's emphasis on convertible securities that offer pronounced downside protection allowed us to outperform the overall equity market amid a downturn in stocks. --------------------------------- INVESTMENT PHILOSOPHY THE ADVISER BELIEVES THAT A REASONABLE LEVEL OF CURRENT INCOME AND LONG-TERM GROWTH IN CAPITAL CAN BE ACHIEVED BY INVESTING IN A BROADLY DIVERSIFIED GROUP OF CONVERTIBLE SECURITIES THAT PROVIDE ATTRACTIVE COMBINATIONS OF CURRENT INCOME AND POTENTIAL FOR PRICE APPRECIATION FROM THEIR CONVERTIBILITY INTO COMMON STOCK. --------------------------------- THE INVESTMENT ENVIRONMENT The extreme market volatility we witnessed over the past several months is exactly the type of environment in which a convertible securities portfolio can do reasonably well. The prices of many of our holdings held up nicely, even though the values of some of the underlying common stocks faltered. This occurred for several reasons, but notably because the fixed income market was generally strong and because there was some improvement in the credit quality of the convertible securities market. The convertibles market was also affected during the period by a massive amount of new issuance, most of it coming from investment-grade companies. We estimated the investment value of many of these new issues--that is, the hypothetical values of the securities sans their convertibility features--to be quite high, suggesting that they entailed minimal risk. These deals came from a variety of issuers and were well diversified by industry. We expect new issuance to remain strong in the near term. THE FUND'S SUCCESSES Positive contributors to the fund's six-month performance came from a variety of industries. The fund's exposure to utilities certainly helped, with holdings such as Calpine and Mirant turning in solid results. Our health care exposure continued to benefit us, with IVAX, Express Scripts, and numerous biotech companies all performing well. The fund also got a boost from the announcement that Johnson & Johnson would acquire ALZA. Our ALZA bonds will become triple A-rated and convertible into Johnson & Johnson common stock. Other broad areas of success were the transportation, consumer goods, 5 and energy industries. Among our holdings in these areas are Union Pacific, Charter Communications, and Devon Energy (exchangeable for shares in Chevron). THE FUND'S SHORTFALLS The primary negative for the convertibles market--and for the fund--during the period was the continued decline in telecommunications stocks. The sector continued to suffer from concern over future financing and the inability of many companies to meet their business goals. Disappointing holdings included convertibles from Level 3 Communications and XO Communications. OUR POSITION The fund remains 100% invested in convertible securities and is well diversified by company and industry. Amid these unsettled markets, our major focus is on careful credit analysis of sectors and individual holdings. This leads us to favor higher-rated securities with intermediate-term maturities and attractive yields. The fund's average credit quality remains at BB. As always, we hold convertible securities that we believe offer a clear imbalance of upside potential relative to downside risk. We continue to see a high level of uncertainty in the financial markets, but we think the portfolio is well positioned for such an environment. Larry Keele, Portfolio Manager June 15, 2001 6 PORTFOLIO CHANGES SIX MONTHS ENDED MAY 31, 2001 COMMENTS -------------------------------------------------------------------------------- NEW HOLDINGS ------------ IVAX Pharmaceutical company focused on 4.50%, due 5/15/2008 the generic segment; 7-year convertible bond issued with moderate 25% conversion premium. Washington Mutual Large financial services firm; convertible 5.375%, convertible issued at $50 per share carrying a 5.375% preferred current yield and 26% conversion premium; rated A3/BBB-;. Northrop Grumman Major aerospace/defense firm issued 7.0%, convertible convertible in partial consideration for the preferred purchase of Litton Industries; convertible carries seven years of call protection and high current yield. NTL Communications Telecommunications firm with focus on 6.75%, due 5/15/2008 delivering cable television, Internet access, and telephone service to business and residential customers in European markets; newly issued convertible with 6.75% yield and 27% conversion premium. ================================================================================ ELIMINATED ---------- Level 3 Communications Stock declined sharply in 6.0%, due 9/15/2009 telecommunications slowdown; conversion premium became too high (north of 100%) for our strategy. Offshore Logistics Stock appreciation lifted these currently 6.0%, due 12/15/2003 callable bonds to our target price level. Baker Hughes Bonds were called. 0.0%, due 5/05/2008 -------------------------------------------------------------------------------- See page 12 for a complete listing of the FUND'S HOLDINGS. 7 FUND PROFILE As of May 31, 2001 for Convertible Securities Fund This Profile provides a snapshot of the fund's characteristics, compared where appropriate to an unmanaged broad market index. Key terms are defined on pages 9-10. ---------------------------------------- FINANCIAL ATTRIBUTES Number of Securities 81 Yield 3.7% Conversion Premium 29.4% Average Weighted Maturity 4.9 years Average Coupon 3.9% Average Quality BB Average Duration 4.0 years Foreign Holdings 2.0% Turnover Rate 152%* Expense Ratio 0.54%* Cash Investments 3.2% ---------------------------------------- --------------------------- DISTRIBUTION BY CREDIT QUALITY (% of bonds) Aaa/AAA 1.2% Aa/AA 0.0 A/A 5.7 Baa/BBB 19.6 Ba/BB 18.7 B/B 32.9 Less than B/B 6.5 Not Rated 15.4 --------------------------- Total 100.0% --------------------------- --------------------------------------------- TEN LARGEST HOLDINGS (% of total net assets) IVAX Corp. 3.4% (pharmaceuticals) Pride International, Inc. 3.3 (energy) Charter Communications, Inc. 3.3 (telecommunications) International Rectifier Corp. 2.8 (electronics) Titan Capital Trust 2.8 (telecommunications) Weatherford International, Inc. 2.5 (oil) Union Pacific Capital Trust 2.3 (railroad) Rational Software Corp. 2.3 (software) L-3 Communications Holdings, Inc. 2.3 (electronics) Washington Mutual Capital Trust I 2.2 (savings & loan) --------------------------------------------- Top Ten 27.2% --------------------------------------------- -------------------------------------- VOLATILITY MEASURES WILSHIRE FUND 5000 -------------------------------------- R-Squared 0.67 1.00 Beta 0.77 1.00 -------------------------------------- -------------------------------------- DISTRIBUTION BY MATURITY (% of bonds) Under 1 Year 4.7% 1-5 Years 43.3 5-10 Years 52.0 10-20 Years 0.0 20-30 Years 0.0 Over 30 Years 0.0 -------------------------------------- Total 100.0% -------------------------------------- *Annualized. [PHOTO OF COMPUTER] VISIT OUR WEBSITE WWW.VANGUARD.COM FOR REGULARLY UPDATED FUND INFORMATION. 8 ------------------------------------------- SECTOR DIVERSIFICATION (% of portfolio) Auto & Transportation 3.6% Consumer Discretionary 6.5 Consumer Staples 0.9 Financial Services 7.8 Health Care 19.6 Integrated Oils 1.7 Other Energy 15.1 Materials & Processing 2.4 Producer Durables 14.0 Technology 13.6 Utilities 14.8 Other 0.0 ------------------------------------------- GLOSSARY of Investment Terms AVERAGE COUPON. The average interest rate paid on the securities held by a fund. It is expressed as a percentage of face value. -------------------------------------------------------------------------------- AVERAGE DURATION. An estimate of how much a bond fund's share price will fluctuate in response to a change in interest rates. To see how the price could shift, multiply the fund's duration by the change in rates. If interest rates rise by one percentage point, the share price of a fund with an average duration of five years would decline by about 5%. If rates decrease by a percentage point, the fund's share price would rise by 5%. -------------------------------------------------------------------------------- AVERAGE QUALITY. An indicator of credit risk, this figure is the average of the ratings assigned to a fund's holdings by credit-rating agencies. The agencies make their judgment after appraising an issuer's ability to meet its obligations. Quality is graded on a scale, with Aaa or AAA indicating the most creditworthy bond issuers. -------------------------------------------------------------------------------- AVERAGE WEIGHTED MATURITY. The average length of time until securities held by a fund reach maturity (or are called) and are repaid. In general, the longer the average weighted maturity, the more a fund's share price will fluctuate in response to changes in market interest rates. -------------------------------------------------------------------------------- BETA. A measure of the magnitude of a fund's past share-price fluctuations in relation to the ups and downs of the overall market (or appropriate market index). The market (or index) is assigned a beta of 1.00, so a fund with a beta of 1.20 would have seen its share price rise or fall by 12% when the overall market rose or fell by 10%. -------------------------------------------------------------------------------- CASH INVESTMENTS. The percentage of a fund's net assets invested in "cash equivalents"--highly liquid, short-term, interest-bearing securities. -------------------------------------------------------------------------------- 9 CONVERSION PREMIUM. The average percentage by which the weighted average market price of the convertible securities held by a fund exceeds the weighted average market price of their underlying common stocks. For example, if a stock is trading at $25 per share and a bond convertible into the stock is trading at a price equivalent to $30 per share of stock, the conversion premium is 20% ($5 / $25 = 20%). -------------------------------------------------------------------------------- EXPENSE RATIO. The percentage of a fund's average net assets used to pay its annual administrative and advisory expenses. These expenses directly reduce returns to investors. -------------------------------------------------------------------------------- FOREIGN HOLDINGS. The percentage of a fund's net assets represented by securities of com-panies based outside the United States. -------------------------------------------------------------------------------- R-SQUARED. A measure of how much of a fund's past returns can be explained by the returns from the overall market (or its benchmark index). If a fund's total returns were precisely synchronized with the overall market's return, its R-squared would be 1.00. If the fund's returns bore no relationship to the market's returns, its R-squared would be 0. -------------------------------------------------------------------------------- TURNOVER RATE. An indication of the fund's trading activity. Funds with high turnover rates incur higher transaction costs and are more likely to distribute capital gains (which are taxable to investors). -------------------------------------------------------------------------------- YIELD. A snapshot of a fund's income from interest and dividends. The yield, expressed as a percentage of the fund's net asset value, is based on income earned over the past 30 days and is annualized, or projected forward for the coming year. -------------------------------------------------------------------------------- 10 PERFORMANCE SUMMARY for Convertible Securities Fund All of the data on this page represent past performance, which cannot be used to predict future returns that may be achieved by the fund. Note, too, that both share price and return can fluctuate widely. An investor's shares, when redeemed, could be worth more or less than their original cost. ------------------------------------------------------------------ TOTAL INVESTMENT RETURNS (%) November 30, 1990-May 31, 2001 [BAR CHART SCALE -20% TO 40%] CONVERTIBLE CS FIRST BOSTON SECURITIES FUND CONVERTIBLE INDEX ------------------------------------------------------------------ 1991 29.2% 24.6% 1992 26.0 21.7 1993 13.9 19.2 1994 -4.4 -3.9 1995 17.1 24.0 1996 14.9 15.3 1997 14.8 15.4 1998 -2.2 1.4 1999 24.8 30.6 2000 5.3 1.5 2001** 7.6 4.1 ------------------------------------------------------------------ *Six months ended May 31, 2001. See Financial Highlights table on page 17 for dividend and capital gains information for the past five years. 11 FINANCIAL STATEMENTS May 31, 2001 (unaudited) STATEMENTS OF NET ASSETS This Statement provides a detailed list of the fund's holdings, including each security's market value on the last day of the reporting period. Securities are grouped and subtotaled by asset type (common stocks, bonds, etc.) and by industry sector. Other assets are added to, and liabilities are subtracted from, the value of Total Investments to calculate the fund's Net Assets. Finally, Net Assets are divided by the outstanding shares of the fund to arrive at its share price, or Net Asset Value (NAV) Per Share. At the end of the Statement of Net Assets, you will find a table displaying the composition of the fund's net assets on both a dollar and per-share basis. Because all income and any realized gains must be distributed to shareholders each year, the bulk of net assets consists of Paid-in Capital (money invested by shareholders). The amounts shown for Undistributed Net Investment Income and Accumulated Net Realized Gains usually approximate the sums the fund had available to distribute to shareholders as income dividends or capital gains as of the statement date, but may differ because certain investments or transactions may be treated differently for financial statement and tax purposes. Any Accumulated Net Realized Losses, and any cumulative excess of distributions over net income or net realized gains, will appear as negative balances. Unrealized Appreciation (Depreciation) is the difference between the market value of the fund's investments and their cost, and reflects the gains (losses) that would be realized if the fund were to sell all of its investments at their statement-date values. -------------------------------------------------------------------------------- FACE MARKET AMOUNT VALUE^ CONVERTIBLE SECURITIES FUND (000) (000) -------------------------------------------------------------------------------- CONVERTIBLE BONDS (77.0%) -------------------------------------------------------------------------------- AUTO & TRANSPORTATION (1.1%) United Parcel Service, Inc. 1.75%, 9/27/2007 $ 3,685 $ 3,766 -------- CONSUMER DISCRETIONARY(5.4%) Echostar Communications Corp. 4.875%, 1/1/2007 5,705 5,020 Lamar Advertising Co. 5.25%, 9/15/2006 745 817 Lowe's Companies, Inc. (1) 0.00%, 2/16/2021 8,790 6,134 Waste Connections, Inc. (1)5.50%, 4/15/2006 3,680 3,717 XM Satellite Radio Holdings Inc. 7.75%, 3/1/2006 1,815 2,400 -------- 18,088 -------- CONSUMER STAPLES (0.9%) Fleming Companies, Inc. (1) 5.25%, 3/15/2009 2,450 3,050 -------- FINANCIAL SERVICES (5.4%) Affiliated Computer Services, Inc. (1) 3.50%, 2/15/2006 5,950 6,393 Bisys Group, Inc. (1) 4.00%, 3/15/2006 2,000 2,041 National Data Corp. 5.00%, 11/1/2003 2,510 2,519 Providian Financial Corp. 3.25%, 8/15/2005 6,825 7,051 -------- 18,004 -------- HEALTH CARE (17.7%) ALZA Corp. 0.00%, 7/28/2020 9,930 7,063 AmeriSource Health Corp. (1) 5.00%, 12/1/2007 4,450 5,935 Aviron 5.25%, 2/1/2008 1,765 1,893 Cephalon, Inc. (1)5.25%, 5/1/2006 4,155 4,289 Human Genome Sciences, Inc. 3.75%, 3/15/2007 7,545 6,442 Imclone Systems, Inc. 5.50%, 3/1/2005 5,690 6,301 Invitrogen Corp. 5.50%, 3/1/2007 2,820 3,165 IVAX Corp. (1)4.50%, 5/15/2008 4,755 5,076 5.50%, 5/15/2007 4,845 6,383 Protein Design Labs Inc. 5.50%, 2/15/2007 1,775 2,183 Province Healthcare Co. 4.50%, 11/20/2005 1,620 1,521 12 -------------------------------------------------------------------------------- FACE MARKET AMOUNT VALUE* (000) (000) -------------------------------------------------------------------------------- Total Renal Care Holdings 5.625%, 7/15/2006 $ 2,575 $ 2,541 Universal Health Services, Inc. 0.426%, 6/23/2020 11,925 6,484 -------- 59,276 -------- INTEGRATED OILS (1.6%) Kerr-McGee Corp. 5.25%, 2/15/2010 4,245 5,471 -------- OTHER ENERGY (13.1%) Devon Energy Corp. 4.95%, 8/15/2008 5,135 5,270 El Paso Corp. (1)0.00%, 2/28/2021 14,735 6,290 Hanover Compressor Co. 4.75%, 3/15/2008 3,215 3,496 Nabors Industries, Inc. 0.00%, 6/20/2020 7,530 5,149 Pogo Producing Co. 5.50%, 6/15/2006 3,080 2,957 Pride International, Inc. 0.00%, 4/24/2018 23,515 11,104 SEACOR Holdings, Inc. 5.375%, 11/15/2006 1,215 1,325 Weatherford International, Inc. 0.00%, 6/30/2020 12,345 8,395 -------- 43,986 -------- MATERIALS & PROCESSING (1.5%) Inco Ltd. (1) 0.00%, 3/29/2021 8,485 4,932 -------- PRODUCER DURABLES (12.5%) American Tower Corp. 2.25%, 10/15/2009 1,885 1,748 6.25%, 10/15/2009 4,300 5,319 Briggs & Stratton Corp. (1) 5.00%, 5/15/2006 2,845 3,041 Brooks Automation, Inc. (1) 4.75%, 6/1/2008 1,130 1,093 EMCORE Corp. (1) 5.00%, 5/15/2006 4,400 4,202 Foster Wheeler Corp. (1)6.50%, 6/1/2007 3,385 3,368 Kulicke & Soffa Industries, Inc. 4.75%, 12/15/2006 2,075 1,829 L-3 Communications Holdings, Inc. 5.25%, 6/1/2009 5,915 7,542 Lam Research Corp. (1) 4.00%, 6/1/2006 3,510 3,356 PerkinElmer Inc. 0.00%, 8/7/2020 5,520 3,088 Tyco International Ltd. 0.00%, 11/17/2020 9,245 7,165 -------- 41,751 -------- TECHNOLOGY (10.4%) Celestica, Inc. 0.00%, 8/1/2020 4,145 1,828 Comverse Technology, Inc. 1.50%, 12/1/2005 7,485 6,325 Globespan, Inc. (1)5.25%, 5/15/2006 445 344 International Rectifier Corp. 4.25%, 7/15/2007 9,205 9,482 nVidia Corp. 4.75%, 10/15/2007 3,385 3,973 Rational Software Corp. 5.00%, 2/1/2007 7,880 7,663 Semtech Corp. 4.50%, 2/1/2007 5,660 5,094 -------- 34,709 -------- UTILITIES (7.4%) Adelphia Communications 6.00%, 2/15/2006 4,915 4,718 Charter Communications, Inc. 4.75%, 6/1/2006 4,305 4,472 5.75%, 10/15/2005 5,420 6,579 NTL Communications Corp. (1)6.75%, 5/15/2008 5,850 5,148 NTL Inc. 7.00%, 12/15/2008 4,690 3,588 -------- 24,505 -------- -------------------------------------------------------------------------------- TOTAL CONVERTIBLE BONDS (COST $245,518) 257,538 -------------------------------------------------------------------------------- Shares -------------------------------------------------------------------------------- CONVERTIBLE PREFERRED STOCKS (19.8%) -------------------------------------------------------------------------------- AUTO & TTRANSPORTATION(2.3%) Union Pacific Capital Trust 6.25% Cvt. Pfd. 161,600 7,797 -------- CONSUMER DISCRETIONARY (0.9%) Kmart Financing 7.75% Cvt. Pfd. 60,700 2,854 -------- FINANCIAL SERVICES (2.2%) *(1) Washington Mutual Capital Trust I 5.375% Cvt. Pfd. 142,700 7,385 -------- HEALTH CARE (1.2%) Express Scripts, Inc. 7.00% Cvt. Pfd. 45,100 4,129 -------- OTHER ENERGY (1.4%) Apache Corp. 6.50% Cvt. Pfd. 54,000 2,712 Pogo Trust I 6.50% Cvt. Pfd. 31,600 2,082 -------- 4,794 -------- MATERIALS & PROCESSING (0.9%) Sealed Air Corp. $2.00 Cvt. Pfd. 66,100 2,875 -------- 13 -------------------------------------------------------------------------------- MARKET VALUE* CONVERTIBLE SECURITIES FUND SHARES (000) -------------------------------------------------------------------------------- PRODUCER DURABLES (1.1%) Northrop Grumman Corp. 0.0% Cvt. Pfd. 33,100 $ 3,658 -------- TECHNOLOGY (2.8%) Titan Capital Trust 5.75% Cvt. Pfd. 271,900 9,244 -------- UTILITIES (7.0%) AES Trust VII 6.00% Cvt. Pfd. 78,200 4,575 Calpine Capital Trust III 5.00% Cvt. Pfd. 78,800 5,250 Dominion Resources, Inc. 9.50% Cvt. Pfd. 82,400 5,140 Mirant Trust I 6.25% Cvt. Pfd. 28,400 2,304 Broadwing Inc. 6.75% Cvt. Pfd. 139,600 6,282 -------- 23,551 -------- -------------------------------------------------------------------------------- TOTAL CONVERTIBLE PREFERRED STOCKS (COST $63,740) 66,287 -------------------------------------------------------------------------------- FACE AMOUNT (000) -------------------------------------------------------------------------------- TEMPORARY CASH INVESTMENTS (3.7%) -------------------------------------------------------------------------------- REPURCHASE AGREEMENTS Collateralized by U.S. Government Obligations in a Pooled Cash Account 4.14%, 6/1/2001--Note F $10,824 10,824 4.15%, 6/1/2001 1,589 1,589 -------------------------------------------------------------------------------- TOTAL TEMPORARY CASH INVESTMENTS (COST $12,413) 12,413 -------------------------------------------------------------------------------- TOTAL INVESTMENTS (100.5%) (Cost $321,671) 336,238 -------------------------------------------------------------------------------- OTHER ASSETS AND LIABILITIES (-0.5%) -------------------------------------------------------------------------------- Other Assets--Note C $ 10,577 Security Lending Collateral Payable to Brokers--Note F (10,824) Other Liabilities (1,318) -------- (1,565) -------- -------------------------------------------------------------------------------- NET ASSETS (100%) -------------------------------------------------------------------------------- Applicable to 26,068,018 outstanding $.001 par value shares of beneficial interest (unlimited authorization) $334,673 ================================================================================ NET ASSET VALUE PER SHARE $12.84 ================================================================================ ^ See Note A in Notes to Financial Statements. * Non-income-producing security. (1)Security exempt from registration under Rule 144A of the Securities Act of 1933. These securities may be sold in transactions exempt from registration, normally to qualified institutional buyers. At May 31, 2001, the aggregate value of these securities was $75,794,000, representing 22.6% of net assets. -------------------------------------------------------------------------------- AT MAY 31, 2001, NET ASSETS CONSISTED OF: -------------------------------------------------------------------------------- AMOUNT PER (000) SHARE -------------------------------------------------------------------------------- Paid-in Capital $345,567 $13.26 Undistributed Net Investment Income--Note D 2,618 .10 Accumulated Net Realized Losses--Note D (28,079) (1.08) Unrealized Appreciation--Note E 14,567 .56 -------------------------------------------------------------------------------- NET ASSETS $334,673 $12.84 ================================================================================ 14 STATEMENT OF OPERATIONS This Statement shows dividend and interest income earned by the fund during the reporting period, and details the operating expenses charged to the fund. These expenses directly reduce the amount of investment income available to pay to shareholders as dividends. This Statement also shows any Net Gain (Loss) realized on the sale of investments, and the increase or decrease in the Unrealized Appreciation (Depreciation) on investments during the period. -------------------------------------------------------------------------------- CONVERTIBLE SECURITIES FUND SIX MONTHS ENDED MAY 31, 2001 (000) -------------------------------------------------------------------------------- INVESTMENT INCOME INCOME Dividends $ 1,871 Interest 5,801 Security Lending 69 -------------------------------------------------------------------------------- Total Income 7,741 -------------------------------------------------------------------------------- EXPENSES Investment Advisory Fees--Note B Basic Fee 662 Performance Adjustment (244) The Vanguard Group--Note C Management and Administrative 447 Marketing and Distribution 20 Custodian Fees 6 Auditing Fees 4 Shareholders' Reports 16 -------------------------------------------------------------------------------- Total Expenses 911 -------------------------------------------------------------------------------- NET INVESTMENT INCOME 6,830 -------------------------------------------------------------------------------- REALIZED NET GAIN (LOSS) ON INVESTMENT SECURITIES SOLD (27,960) -------------------------------------------------------------------------------- CHANGE IN UNREALIZED APPRECIATION (DEPRECIATION) OF INVESTMENT SECURITIES 45,098 -------------------------------------------------------------------------------- NET INCREASE (DECREASE) IN NET ASSETS RESULTING FROM OPERATIONS $23,968 ================================================================================ 15 STATEMENT OF CHANAGES IN NET ASSETS This Statement shows how the fund's total net assets changed during the two most recent reporting periods. The Operations section summarizes information detailed in the Statement of Operations. The amounts shown as Distributions to shareholders from the fund's net income and capital gains may not match the amounts shown in the Operations section, because distributions are determined on a tax basis and may be made in a period different from the one in which the income was earned or the gains were realized on the financial statements. The Capital Share Transactions section shows the amount shareholders invested in the fund, either by purchasing shares or by reinvesting distributions, as well as the amounts redeemed. The corresponding numbers of Shares Issued and Redeemed are shown at the end of the Statement. -------------------------------------------------------------------------------- CONVERTIBLE SECURITIES FUND ------------------------------------ SIX MONTHS YEAR ENDED ENDED MAY 31, 2001 NOV. 30, 2000 (000) (000) -------------------------------------------------------------------------------- INCREASE (DECREASE) IN NET ASSETS OPERATIONS Net Investment Income $ 6,830 $ 12,619 Realized Net Gain (Loss) (27,960) 19,964 Change in Unrealized Appreciation (Depreciation) 45,098 (43,816) -------------------------------------------------------------------------------- Net Increase (Decrease) in Net Assets Resulting from Operations 23,968 (11,233) -------------------------------------------------------------------------------- DISTRIBUTIONS net Investment Income (6,940) (11,273) Realized Capital Gain (12,982) (9,590) -------------------------------------------------------------------------------- Total Distributions (19,922) (20,863) -------------------------------------------------------------------------------- CAPITAL SHARE TRANSACTIONS1 Issued 44,237 241,127 Issued in Lieu of Cash Distributions 17,966 18,490 Redeemed (55,034) (83,695) -------------------------------------------------------------------------------- Net Increase (Decrease) from Capital Share Transactions 7,169 175,922 -------------------------------------------------------------------------------- Total Increase (Decrease) 11,215 143,826 -------------------------------------------------------------------------------- NET ASSETS Beginning of Period 323,458 179,632 -------------------------------------------------------------------------------- End of Period $334,673 $323,458 ================================================================================ 1Shares Issued (Redeemed) Issued 3,432 16,351 Issued in Lieu of Cash Distributions 1,438 1,342 Redeemed (4,314) (5,811) -------------------------------------------------------------------------------- Net Increase (Decrease) in Shares Outstanding 556 11,882 ================================================================================ 16 FINANCIAL HIGHLIGHTS This table summarizes the fund's investment results and distributions to shareholders on a per-share basis. It also presents the fund's Total Return and shows net investment income and expenses as percentages of average net assets. These data will help you assess: the variability of the fund's net income and total returns from year to year; the relative contributions of net income and capital gains to the fund's total return; how much it costs to operate the fund; and the extent to which the fund tends to distribute capital gains. The table also shows the Portfolio Turnover Rate, a measure of trading activity. A turnover rate of 100% means that the average security is held in the fund for one year.
----------------------------------------------------------------------------------------------------- CONVERTIBLE SECURITIES FUND YEAR ENDED NOVEMBER 30, FOR A SHARE OUTSTANDING SIX MONTHS ENDED ------------------------------------------------- THROUGHOUT EACH PERIOD MAY 31, 2001 2000 1999 1998 1997 1996 ----------------------------------------------------------------------------------------------------- NET ASSET VALUE, BEGINNING OF PERIO $12.68 $13.18 $11.10 $13.01 $13.07 $12.03 ----------------------------------------------------------------------------------------------------- INVESTMENT OPERATIONS Net Investment Income .27 .56 .52 .52 .53 .43 Net Realized and Unrealized Gain (Loss) on Investments .67 .19 2.13 (.77) 1.17 1.29 ----------------------------------------------------------------------------------------------------- Total from Investment Operations .94 .75 2.65 (.25) 1.70 1.72 ----------------------------------------------------------------------------------------------------- DISTRIBUTIONS Dividends from Net Investment Income (.27) (.55) (.57) (.54) (.47) (.54) Distributions from Realized Capital Gains (.51) (.70) -- (1.12) (1.29) (.14) ----------------------------------------------------------------------------------------------------- Total Distributions (.78) (1.25) (.57) (1.66) (1.76) (.68) ----------------------------------------------------------------------------------------------------- NET ASSET VALUE, END OF PERIOD $12.84 $12.68 $13.18 $11.10 $13.01 $13.07 ===================================================================================================== TOTAL RETURN 7.63% 5.27% 24.85% -2.16% 14.81% 14.88% ===================================================================================================== RATIOS/SUPPLEMENTAL DATA Net Assets, End of Period (Millions) $335 $323 $180 $172 $189 $170 Ratio of Total Expenses to Average Net Assets 0.54%* 0.56% 0.55% 0.73% 0.67% 0.69% Ratio of Net Investment Income to Average Net Assets 4.08%* 4.19% 4.30% 4.36% 4.29% 3.43% Portfolio Turnover Rate 152%* 182% 162% 186% 182% 97% ===================================================================================================== *Annualized.
17 NOTES TO FINANCIAL STATEMENTS Vanguard Convertible Securities Fund is registered under the Investment Company Act of 1940 as an open-end investment company, or mutual fund. 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: Equity securities are valued at the latest quoted sales prices as of the close of trading on the New York Stock Exchange (generally 4:00 p.m. Eastern time) on the valuation date; such securities not traded on the valuation date are valued at the mean of the latest quoted bid and asked prices. Prices are taken from the primary market in which each security trades. Bonds 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. Temporary cash investments are valued at cost, which approximates market value. Securities for which market quotations are not readily available are valued by methods deemed by the board of trustees to represent fair value. 2. FEDERAL INCOME TAXES: The fund intends to continue to qualify as a regulated investment company and distribute all of its taxable income. Accordingly, no provision for federal income taxes is required in the financial statements. 3. REPURCHASE AGREEMENTS: The fund, along with other members of The Vanguard Group, transfers uninvested cash balances to a pooled cash account, which is invested in repurchase agreements secured by U.S. government securities. Securities pledged as collateral for repurchase agreements are held by a custodian bank until the agreements mature. Each agreement requires that the market value of the collateral be sufficient to cover payments of interest and principal; however, in the event of default or bankruptcy by the other party to the agreement, retention of the collateral may be subject to legal proceedings. 4. DISTRIBUTIONS: Distributions to shareholders are recorded on the ex-dividend date. Distributions are determined on a tax basis and may differ from net investment income and realized capital gains for financial reporting purposes. 5. OTHER: Dividend income is recorded on the ex-dividend date. Security transactions are accounted for on the date the 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. Discounts on debt securities purchased are accreted to interest income over the lives of the respective securities. B. Oaktree Capital Management, LLC, provides investment advisory services to the fund for a fee calculated at an annual percentage rate of average net assets. The basic fee is subject to quarterly adjustments based on performance for the preceding three years relative to the Credit Suisse First Boston Convertible Securities Index. For the six months ended May 31, 2001, the advisory fee represented an effective annual basic rate of 0.40% of the fund's average net assets before a decrease of $244,000 (0.15%) based on performance. C. The Vanguard Group furnishes at cost 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 May 31, 2001, the fund had contributed capital of $63,000 to Vanguard (included in Other Assets), representing 0.02% of the fund's net assets and 0.06% of Vanguard's capitalization. The fund's trustees and officers are also directors and officers of Vanguard. 18 D. During the six months ended May 31, 2001, the fund purchased $243,584,000 of investment securities and sold $249,463,000 of investment securities, other than temporary cash investments. Certain of the fund's convertible preferred stock investments are treated as debt securities for tax purposes. During the six months ended May 31, 2001, the fund realized gains of $106,000 from the sale of these securities which are included in distributable net investment income for tax purposes; accordingly, such gains have been reclassified from accumulated net realized gains to undistributed net investment income. E. At May 31, 2001, net unrealized appreciation of investment securities for financial reporting and federal income tax purposes was $14,567,000, consisting of unrealized gains of $25,634,000 on securities that had risen in value since their purchase and $11,067,000 in unrealized losses on securities that had fallen in value since their purchase. F. The market value of securities on loan to broker/dealers at May 31, 2001, was $10,521,000, for which the fund held cash collateral of $10,824,000. The fund invests cash collateral received in repurchase agreements, and records a liability for the return of the collateral, during the period the securities are on loan. G. In November 2000, the American Institute of Certified Public Accountants issued new accounting guidelines for investment companies which will require the fund to change its accounting policies to begin to amortize premiums on convertible bonds effective for the fiscal year ending November 30, 2002. This accounting change will not affect the fund's net asset value or total return, but may result in certain amounts being reclassified from interest income to realized and unrealized gain for financial statement purposes. Management believes this change will have no material effect on the financial statements. 19 THE ADVANTAGES OF GETTING CONNECTED Visit Vanguard.com [COMPUTER GRAPHIC] Why wait for the mail? You can get fund reports like this one sooner--and reduce the amount of mail you receive from us. Simply choose to view your fund reports online. Consider the benefits of using VANGUARD.COM. On our website, you can: **Choose to receive all fund reports, as well as prospectuses, online. **Request a courtesy e-mail to notify you when a new fund report or prospectus is available. When you receive fund reports and prospectuses online, you lower Vanguard's printing and postage costs--and that helps to reduce the expense ratios of your funds. You will continue to receive confirmations of purchases, redemptions, and other account activity by mail. HOW TO NOTIFY US ABOUT YOUR MAILING PREFERENCES You can easily tell us to stop mailing your fund reports and prospectuses. Just log on to Vanguard.com (or follow the easy steps to register for secure, online access to your accounts) and update your Web profile. Registered users can also view their account values; download records of recent transactions; research and track the performance of individual securities and funds; buy, exchange, and sell fund shares; and much more. If you invest directly with us, you can also elect to receive all of your account statements online or to continue the mailing of only your year-end statements, which detail every transaction you make during the year. However, if you invest with us through an employer-sponsored retirement plan or a financial intermediary, some of these options may not be available to you. All Vanguard shareholders can choose to receive our electronic newsletters: ECONOMIC WEEK IN REVIEW, a recap of each week's key economic reports and market activity; and WHAT'S NEW AT VANGUARD, a monthly update on our mutual funds, services, and online resources. YOUR ONLINE INFORMATION IS SECURE Vanguard.com uses some of the most secure forms of online communication available, including data encryption and Secure Sockets Layer (SSL) protocol. These technologies provide a high level of security and privacy when you access your account information, initiate online transactions, or send us messages. 20 THE PEOPLE Who Govern Your Fund The trustees of your mutual fund are there to see that the fund is operated and managed in your best interests since, as a shareholder, you are part owner of the fund. Your fund trustees also serve on the board of directors of The Vanguard Group, which is owned by the funds and exists solely to provide services to them on an at-cost basis. The majority of Vanguard's board members are independent, meaning that they have no affiliation with Vanguard or the funds they oversee, apart from the sizable personal investments they have made as private individuals. They bring distinguished backgrounds in business, academia, and public service to their task of working with Vanguard officers to establish the policies and oversee the activities of the funds. Among board members' responsibilities are selecting investment advisers for the funds; monitoring fund operations, performance, and costs; reviewing contracts; nominating and selecting new trustees/ directors; and electing Vanguard officers. The list below provides a brief description of each trustee's professional affiliations. The year in which the trustee joined the Vanguard board is noted in parentheses. -------------------------------------------------------------------------------- TRUSTEES JOHN J. BRENNAN (1987) Chairman of the Board, Chief Executive Officer, and Director/Trustee of The Vanguard Group, Inc., and of each of the investment companies in The Vanguard Group. CHARLES D. ELLIS (2001) Retired Managing Partner of Greenwich Associates; Successor Trustee of Yale University; Overseer of the Stern School of Business at New York University; Trustee of the Whitehead Institute for Biomedical Research. JOANN HEFFERNAN HEISEN (1998) Vice President, Chief Information Officer, and a member of the Executive Committee of Johnson & Johnson; Director of Johnson & Johnson*Merck Consumer Pharmaceuticals Co., The Medical Center at Princeton, and Women's Research and Education Institute. BRUCE K. MACLAURY (1990) President Emeritus of The Brookings Institution; Director of American Express Bank Ltd., The St. Paul Companies, Inc., and National Steel Corp. BURTON G. MALKIEL (1977) Chemical Bank Chairman's Professor of Economics, Princeton University; Director of Prudential Insurance Co. of America, Banco Bilbao Argentaria, Gestion, BKF Capital, The Jeffrey Co., NeuVis, Inc., and Select Sector SPDR Trust. ALFRED M. RANKIN, JR. (1993) Chairman, President, Chief Executive Officer, and Director of NACCO Industries, Inc.; Director of The BFGoodrich Co. JAMES O. WELCH, JR. (1971) 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 (1985) Retired Chairman and Chief Executive Officer of Rohm & Haas Co.; Director of AmeriSource Health Corporation, Cummins Engine Co., and The Mead Corp.; Trustee of Vanderbilt University. -------------------------------------------------------------------------------- OTHER FUND OFFICERS RAYMOND J. KLAPINSKY, Secretary; Managing Director and Secretary of The Vanguard Group, Inc.; Secretary of each of the investment companies in The Vanguard Group. THOMAS J. HIGGINS, Treasurer; Principal of The Vanguard Group, Inc.; Treasurer of each of the investment companies in The Vanguard Group. -------------------------------------------------------------------------------- VANGUARD MANAGING DIRECTORS R. GREGORY BARTON, Legal Department. ROBERT A. DISTEFANO, Information Technology. JAMES H. GATELY, Direct Investor Services. KATHLEEN C. GUBANICH, Human Resources. IAN A. MACKINNON, Fixed Income Group. F. WILLIAM MCNABB, III, Institutional Investor Group. MICHAEL S. MILLER, Planning and Development. RALPH K. PACKARD, Chief Financial Officer. GEORGE U. SAUTER, Quantitative Equity Group. -------------------------------------------------------------------------------- JOHN C. BOGLE Founder; Chairman and Chief Executive, 1974-1996. [SHIP GRAPHIC] THE VANGUARD GROUP(R) LOGO Post Office Box 2600 Valley Forge, PA 19482-2600 ABOUT OUR COVER Our cover art evokes both Vanguard's rich past and the course we've set for the future--our determination to provide superior investment performance and top-notch service. The image is based on two works: a painting titled The First Journey of 'Victory,' by he English artist W.L. Wyllie (1851-1931), and a sculpture of a compass rose on Vanguard's campus near Valley Forge, Pennsylvania. All comparative mutual fund data are from Lipper Inc. or Morningstar, Inc., unless otherwise noted. Standard & Poor's(R), S&P(R), S&P 500(R), Standard & Poor's 500, 500, S&P MidCap 400, and S&P SmallCap 600 are trademarks of The McGraw-Hill Companies, Inc. All other index names may contain trademarks and are the exclusive property of their respective owners. WORLD WIDE WEB www.vanguard.com FUND INFORMATION 1-800-662-7447 DIRECT INVESTOR ACCOUNT SERVICES 1-800-662-2739 INSTITUTIONAL INVESTOR SERVICES 1-800-523-1036 This report is intended for the fund's shareholders. It may not be distributed to prospective investors unless it is preceded or accompanied by the current fund prospectus. (C)2001 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. Q822 072001