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Delaware Diversified Income Fund Quarterly commentary December 31, 2015

Overview

During the fourth quarter of 2015, the markets finally took the Federal Reserve at its word and factored in a December liftoff. With the markets telling the Fed that it would be appropriate to raise short-term rates, the actual increase in short-term rates in December was a source of only modest and brief volatility.

U.S. economic indicators showed mixed results throughout the fourth quarter of 2015. Among the more constructive announcements was the U.S. nonfarm payroll release, which showed that 271,000 jobs were added in October, far exceeding the 185,000 expected. This, the highest payrolls print of 2015 so far, helped quell the idea from earlier reports that the pace of employment growth had recently slowed. Overall, housing data and consumer confidence released positive results as well. Although the third-quarter gross domestic product (GDP) estimate was revised slightly downward in December to 2.0% (from the previous reading of 2.1%), data indicated that household purchases boosted demand during the quarter as employment improved and fuel prices remain low. Conversely, U.S. Services Purchasing Managers’ Index (PMI) business activity and manufacturing indicators continued to signal areas of weakness. While more recent U.S. economic indicators were favorable, we acknowledge that these can easily be offset by continued weakness in China, Europe, and emerging market economies, and by subsequent volatility in the equity and commodity markets.

During the fourth quarter, yields on 10-year Treasurys increased from 2.04% to 2.27%, and given the recently announced rate liftoff, yields on 2-year Treasurys rose from 0.63% to 1.05%. The 3-month T-bill / 10-year T-note curve steepened slightly by 6 basis points ending at 2.10%. After the release of the minutes of the Federal Open Market Committee’s October meeting (which seemed to convey that the majority of the Committee members were prepared to raise rates at the next meeting in December), the 1-month London interbank offered rate (Libor) began to climb in mid-November and ended the quarter at 0.43%. (Data: Bloomberg.)

The Barclays U.S. Aggregate Index recorded a negative return in the fourth quarter, with lower-quality bonds underperforming the higher-rated investment tiers within the index. Although most broad-market fixed income indices produced flat to slightly negative returns, emerging market bonds were the strongest performer for the period, with the U.S. corporate high yield sector lagging significantly.

Within the Fund

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

Notes at the sector level follow:

  • Underweight positions in Treasury securities had a positive effect on relative returns as Treasury bonds underperformed other benchmark sectors.
  • The Fund’s position in mortgage-backed securities (MBS) had a negative effect on security-specific positioning.
  • The Fund’s investments in commercial mortgage-backed securities had a negative effect on relative performance based on the Fund’s overweight.
  • Although we have reduced the Fund’s position in investment grade corporate bonds, exposure to these securities hurt relative performance during the quarter due to security selection.
  • The high yield bond market underperformed the benchmark for the quarter. While we reduced the Fund’s exposure to this sector, high yield corporate bonds had a negative effect on relative performance.

Outlook

We believe the U.S. economic expansion should continue at a modest pace, with the upside and downside risks to our growth outlook roughly equal. At this time, we think the Fed’s goal of raising rates four times in 2016 is a lofty one. Furthermore, we believe currency volatility could remain a central theme in 2016. Manufacturing is likely to continue experiencing headwinds as global demand remains under pressure. We believe the path to the Fed’s target of 2% inflation level may be challenged — particularly in the second half of the coming year.

Moving into 2016, we think reduced Treasury supply, coupled with low inflation and competitively low global yields, should help limit upside surprises for domestic rates. Of final note, the importance of central banks’s and sovereign wealth funds’s selling assets should not be underestimated or ignored.

The U.S. Services Purchasing Managers’s Index, or PMI, published by Markit Group, captures business conditions in the U.S. services sector.

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.

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 (12/31/2015)
Current
quarter
YTD1 year3 year5 year10 yearLifetimeInception
date
Class A (NAV)-1.17%-1.15%-1.15%0.82%3.10%5.75%6.85%12/29/1997
Class A (at offer)-5.60%-5.57%-5.57%-0.72%2.17%5.27%6.58%
Institutional Class shares-1.11%-1.01%-1.01%1.07%3.34%6.00%6.68%10/28/2002
Barclays U.S. Aggregate Index-0.57%0.55%0.55%1.44%3.25%4.51%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, non-investment-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 Fund 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