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Delaware Diversified Income Fund Quarterly commentary March 31, 2015

Market overview

In our fourth quarter commentary, we called for “more, not less, volatility in 2015.” During the first quarter of 2015, the markets delivered that volatility right out of the gate. Interest rates dropped significantly during January before retracing and consolidating this yield change during February and March. Intermediate and long maturities led the rate decline while corporate credit returns benefited from a combination of fixed-rate bond duration and an attractively priced yield advantage. During the quarter, the U.S. Federal Reserve ended its reference to “patience” with respect to the timing of a first rate increase. Based on both its words and its “dots,” the Fed seems headed toward a rate increase regime that starts in the second half of 2015 and progresses very gradually. Of course, even this plan will almost certainly diverge from other global central bank policies. Once again we wonder, “Could a 2015 Fed tightening end up being a policy mistake?”

Global economic challenges have led to a currency war, with the United States on one side and virtually everybody else on the other side. Can the rest of the world solve its economic issues by exporting goods to the U.S.? The outcome of this experiment is by no means completely known. Based on recent experience, global gross domestic product (GDP) growth may not respond in a meaningful way. However, as global central banks operate quantitative easing–like policies and create massive liquidity, financial assets could continue to benefit. Portfolio managers must somehow strike a strategic balance that acknowledges the wide dispersion of outcomes potentially resulting from weak economic growth and almost nonexistent inflation, but strong underlying support for financial asset prices.

U.S. economic indicators showed mixed results throughout the first quarter of 2015 suggesting that economic growth has moderated. Data for employment and manufacturing were solid from month to month. Both consumer demand and housing statistics showed weakness. Fourth quarter GDP growth came in unrevised at 2.2%, according to the U.S. Commerce Department. While core inflation was slightly higher during the first quarter, headline prices were lower as falling energy prices provided an important dampening effect. Although the Fed continued its unchanged policy target range of zero to 0.25% (which has been in place since December 2008), it removed the reference to patience from the most recent policy statement. The Federal Open Market Committee (FOMC) made it clear, however, that its dropping the pledge to be “patient” does not guarantee a near-term move in rates. Rather, it will continue to monitor economic data using a data-dependent process.

During the first quarter of 2015, yields on 10-year Treasurys fell from 2.17% to 1.92%, and yields on 2-year Treasurys declined from 0.67% to 0.56%. Rates fell broadly during the first weeks of the quarter but then shifted to a more volatile pattern. The 3-month T-bill / 10-year T-note curve flattened 13 basis points to 1.89% by the end of the quarter. (One basis point is a hundredth of a percentage point.) The 1-month London interbank offered rate (Libor) remained essentially unchanged for the period, ending the quarter at 0.17%. (Data: Bloomberg.)

Within the Fund

Delaware Diversified Income Fund (Institutional Class shares and Class A shares at net asset value) outperformed its benchmark, the Barclays U.S. Aggregate Index, for the first quarter of 2015.

  • The U.S. Treasury sector saw strong returns in the first quarter of 2015 as the majority of U.S. economic releases came in below projections. The Fund’s underweight to Treasurys hurt its relative performance, though the underperformance was offset partially by the use of U.S. Treasury futures positions to balance yield curve exposure and to add some duration.
  • The Fund’s position in mortgage-backed securities (MBS) outperformed the index subsector; however its underweight led to small detractions in the Fund’s relative performance. We continue to concentrate on current coupon investments to take advantage of continued buying by the Fed via its quantitative easing–related reinvestments. We are avoiding midstack coupons, which are experiencing prepayments due to the current low rate environment.
  • The Fund’s investments in commercial mortgage-backed securities (CMBS) added to its relative performance. The Fund’s overweight in this sector includes investments in conduit tranches rated below AAA and subordinate tranches in agency multifamily loan deals.
  • The Fund’s continued overweight in investment grade corporate bonds boosted relative performance during the quarter. Positions in the financials industry particularly drove Fund performance within this part of the market.
  • The high yield bond market was among the stronger sources of performance during the quarter. Investments in bank loans also added to the Fund’s quarterly return.
  • Fund positions in emerging market debt had a slight negative effect on performance for the quarter. Emerging market investments remain challenged by the significant move in both currencies and commodities.
  • Returns among non-dollar developed markets trailed those of the benchmark, as the U.S. dollar remained strong versus the currencies of many other developed nations.

Outlook

Conversations among members of the Delaware Investments fixed income team can touch on almost any topic. Recently, one important topic has been whether deflation may be the bigger risk (relative to inflation) over the next several years. Realistically, we must all admit that, despite the massive money-printing efforts in recent years by key central banks globally, little progress has been made toward hitting inflation targets. We believe something fundamental is at work here, and critically, it could not come at a worse time.

The global debt overhang is challenging enough, but servicing debts during a period of deflation places substantially more pressure on the debtor. Sourcing the needed free cash becomes, by definition, much more difficult. If the debts are owed in other currencies, even governments may not be able to print their way out of the problem. Default risks would rise and these can truly be the most fundamental source of performance challenges in risk assets. Plenty of optimistic and pessimistic market scenarios exist for the near term, but we will continue to try to maintain a balanced, research-driven, risk-managed approach, which we believe can help us maneuver around the challenges to come.

Mortgage-backed securities are fixed income securities that represent pools of mortgages, with investors receiving principal and interest payments as the underlying mortgage loans are paid back. Many are issued and guaranteed against default by the U.S. government or its agencies or instrumentalities, such as Freddie Mac, Fannie Mae, and Ginnie Mae. Others are issued by private financial institutions, with some fully collateralized by certificates issued or guaranteed by the U.S. government or its agencies or instrumentalities.

Bond ratings are determined by a nationally recognized statistical rating organization (NRSRO).

Per Standard & Poor’s credit rating agency, bonds rated below AAA are more susceptible to the adverse effects of changes in circumstances and economic conditions than those in higher-rated categories, but the obligor’s capacity to meet its financial commitment on the obligation is still strong. Bonds rated BBB exhibit adequate protection parameters, although adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments. Bonds rated BB, B, and CCC are regarded as having significant speculative characteristics, with BB indicating the least degree of speculation.

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The views expressed represent the Manager's assessment of the Fund and market environment as of the date indicated, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Information is as of the date indicated and subject to change.

Document must be used in its entirety.

Performance

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance quoted.

Performance data current to the most recent month end may be obtained by calling 800 523-1918 or visiting delawareinvestments.com/performance.

Total returns may reflect waivers and/or expense reimbursements by the manager and/or distributor for some or all of the periods shown. Performance would have been lower without such waivers and reimbursements.

Average annual total return as of quarter-end (03/31/2015)
Current
quarter
YTD1 year3 year5 year10 yearLifetimeInception
date
Class A (NAV)1.89%1.89%4.53%3.68%4.66%6.11%7.35%12/29/1997
Class A (at offer)-2.67%-2.67%-0.23%2.11%3.69%5.62%7.07%
Institutional Class shares1.95%1.95%4.91%3.97%4.94%6.38%7.35%10/28/2002
Barclays U.S. Aggregate Index1.61%1.61%5.72%3.10%4.41%4.93%n/a

Returns for less than one year are not annualized.

Class A shares have a maximum up-front sales charge of 4.50% and are subject to an annual distribution fee.

Barclays U.S. Aggregate Index (view definition)

Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.

Expense ratio
Class A (Gross)0.90%
Class A (Net)0.90%
Institutional Class shares (Gross)0.65%
Institutional Class shares (Net)0.65%

Institutional Class shares are only available to certain investors. See the prospectus for more information. 

All third-party marks cited are the property of their respective owners.

Carefully consider the Fund’s investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Fund’s prospectus and its summary prospectus, which may be obtained by clicking the prospectus link located in the right-hand sidebar or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

Investing involves risk, including the possible loss of principal.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

The Fund may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.

High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.

The high yield secondary market is particularly susceptible to liquidity problems when institutional investors, such as mutual funds and certain other financial institutions, temporarily stop buying bonds for regulatory, financial, or other reasons. In addition, a less liquid secondary market makes it more difficult for the Fund to obtain precise valuations of the high yield securities in its portfolio.

The Funds may invest in derivatives, which may involve additional expenses and are subject to risk, including the risk that an underlying security or securities index moves in the opposite direction from what the portfolio manager anticipated. A derivative transaction depends upon the counterparties’ ability to fulfill their contractual obligations.

If and when the Fund invests in forward foreign currency contracts or uses other investments to hedge against currency risks, the Fund will be subject to special risks, including counterparty risk.

The Fund may experience portfolio turnover in excess of 100%, which could result in higher transaction costs and tax liability.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

All third-party marks cited are the property of their respective owners.

Not FDIC Insured | No Bank Guarantee | May Lose Value