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I was curious about the following threads on NAV and went to Vanguards website for their fund prospectus. It is generally an informative piece - worth the read on general issues with investing in bonds.

However my specific question was how much are Vanguard managers allowed to uses derivatives to manage their interest rate exposure and basically their effective or modified duration. This is their blanket statement regarding all their fixed income funds:

Futures, options, and other derivatives may represent up to 20% of a Fund's total assets. Generally speaking, a derivative is a financial contract whose value is based on the value of a traditional security (such as a stock or bond), an asset (such as a commodity like gold), or a market index (such as the Standard & Poor's 500 Index). Investments in derivatives may subject a Fund to risks different from, and possibly greater than, those of the underlying securities, assets, or market indexes. The Funds' derivatives investments may include bond futures contracts, options, straddles, credit swaps, interest rate swaps, total rate of return swaps, and other types of derivatives. Losses (or gains) involving futures can sometimes be substantial—in part because a relatively small price movement in a futures contract may result in an immediate and substantial loss (or gain) for a fund. Similar risks exist for other types of derivatives. For this reason, the Funds will not use derivatives for speculation or for the purpose of leveraging (magnifying) investment returns. The reasons for which a Fund may invest in futures and other derivatives include:

■To keep cash on hand to meet shareholder redemptions or other needs while simulating full investment in fixed income securities.

■To reduce the Fund's transaction costs or to add value when these instruments are favorably priced.

None of that bothers me as deriatives used sensible can lower transaction costs - etc etc. But to see 20% makes me wonder how generally comparing interest rates and bond NAV's is going to be difficult when the fund manager has so many options (pun intended) to manage the account outside of buying and selling in the cash market.

Anyway just some thoughts


The PDF was called fixedinc.pdf and the quote came from page 35 of the prospectus.
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