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Delaware Diversified Income Fund Quarterly commentary December 31, 2014

Market overview

During the fourth quarter of 2014, the fixed income markets experienced significant bouts of volatility and liquidity pressures, which were clearly evident in rate levels, risk asset spreads, and the shape of the yield curve. Many factors drove the markets, including U.S. dollar strength, commodity/oil price declines, and signs of Russian credit stress. Arguably, the most fundamental factor driving markets during the quarter was the developing dispersion between global central bank policies. While the U.S. Federal Reserve has been moving steadily toward a more restrictive, higher rate policy, central banks in Japan and the euro zone have been increasingly accommodative. After years of consistent central bank policies globally, divergence of policies has introduced substantial currency volatility and this has added volatility into all parts of the financial markets.

Since early October, the fall in oil prices has pressured a specific and meaningful part of the corporate bond market, and this pressure has spread to other parts of the corporate market. Credit spreads are close to highs for the year and fears of some defaults in high yield oil and commodity companies have increased. Emerging market debt has also been weak as many regions have a significant dependence on oil revenues. The dollar is still strong across almost all markets and adds pressure on some emerging market economies with dollar-denominated debt. U.S. economic indicators showed generally strong results throughout the fourth quarter of 2014. While core inflation was slightly higher during the quarter, headline prices were lower as falling energy prices provided an important dampening impact.

During the quarter, yields on 10-year Treasurys fell from 2.49% to 2.17%, and yields on 2-year Treasurys rose from 0.57% to 0.67%. 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 34 basis points to 2.13% by the end of the quarter. (A basis point equals one one-hundredth of a percentage point.) The 1-month London interbank offered rate (Libor) moved slightly higher, ending the quarter at 0.17%. (Data: Bloomberg.)

The Barclays U.S. Aggregate Index recorded a strong return in the fourth quarter as higher-quality bonds and longer-duration sectors led the way. Given the shift in the Treasury yield curve, short-to-intermediate-focused sectors produced lower nominal returns, although mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS) were relatively strong. U.S. Treasury inflation-protected securities (TIPS), high yield corporate bonds, global governments, and emerging market bonds produced negative returns.

Within the Fund

Delaware Diversified Income Fund (Class A and Institutional Class shares at net asset value) underperformed its benchmark, the Barclays U.S. Aggregate Index, for the fourth quarter of 2014.

  • The Fund’s underweight positions in Treasury securities had no impact on relative returns, as Treasury bonds performed in line with the overall benchmark. However, our focus on intermediate maturities contributed modestly to relative outperformance.
  • Government-backed MBS led the benchmark during the quarter. The Fund’s underweight in MBS modestly hurt relative performance while our security-specific positioning generally had a positive effect.
  • Asset-backed securities (ABS) underperformed the benchmark as we maintained our emphasis on short-maturity and floating-rate issues. CMBS provided a slightly negative impact on relative performance based on the Fund’s overweight and lagging security selection.
  • The Fund’s continued overweight in investment grade corporate bonds hurt relative performance during the quarter, as corporate bonds experienced wider credit spreads. Security selection generally had a neutral effect, but down-in-quality lagged.
  • The high yield bond market was among the weakest sources of performance during the quarter. Investments in bank loans showed more moderate, albeit still negative, results.
  • Fund positions in emerging market debt had a negative impact on performance for the quarter. U.S. dollar–based issues experienced wider spreads and issuer-specific downturns.
  • Non-dollar developed markets, while representing only a small allocation, produced negative returns during the quarter as quality concerns hurt performance.

Outlook

Economic growth in the United States looked stronger as the new year began. The outcome on the fundamental, economic front will be the key determinant to the outlook for market yields, spreads, and the Fed. A sustained return to real gross domestic product (GDP) growth of 3–4% over the next several years would likely create a true “sea change” for the Fed and rates.

However, the return to this rate of growth has been the undelivered promise for each of the last four or five years. Even the Fed’s annual forecasts have generally been optimistic on growth only to turn far more pessimistic as the forecasted period approaches. Today, the Fed’s intermediate-term forecast for GDP growth is centered at 2.5%. In the long term, this may turn out to be relatively optimistic, given that demographics have become far less supportive of growth across most developed global economies. The demographic headwind alone could mean that 2–3% GDP growth would be a “best case” scenario over the intermediate term.

Factoring in the boost that growing indebtedness has given to developed world growth in recent decades, the likely headwind from a current debt overhang could, potentially, push expected GDP growth below 2% over the next one to two decades. This (much like the 3–4% example above) could have a major impact on intermediate-term returns in fixed income. Inflation, real rate levels, risk premiums, and again, Fed policy trends could all be changed by a low-growth environment.

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 of the three.

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.

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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.

Because the Fund may invest in bank loans and other direct indebtedness, it is subject to the risk that the Fund will not receive payment of principal, interest, and other amounts due in connection with these investments, which primarily depend on the financial condition of the borrower and the lending institution. A derivative transaction depends upon the counterparties’ ability to fulfill their contractual obligations.

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 (12/31/2014)
Current
quarter
YTD1 year3 year5 year10 yearLifetimeInception
date
Class A (NAV)0.57%5.11%5.11%3.48%4.90%5.79%7.34%12/29/1997
Class A (at offer)-4.00%0.37%0.37%1.91%3.94%5.31%7.05%
Institutional Class shares0.63%5.37%5.37%3.77%5.18%6.06%7.34%10/28/2002
Barclays U.S. Aggregate Index1.79%5.97%5.97%2.66%4.45%4.71%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)

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.

Not FDIC Insured | No Bank Guarantee | May Lose Value