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Delaware Extended Duration Bond Fund Quarterly commentary December 31, 2015

Overview

Financial markets finally took the Federal Reserve (Fed) at its word during the fourth quarter of 2015 and discounted a December “liftoff” of benchmark interest rates. With investors assuring the Fed that it would be appropriate to raise rates, the actual increase in December caused only modest and brief volatility. Going forward, the markets likely will go back into “Fed-watch” mode to anticipate the trajectory of further rate increases over the next 12 to 24 months. Fed “dots” suggest four more 0.25-percentage-point increases in 2016, though the markets look for only two such increases. We lean in favor of the markets’s current view (fewer rather than more increases) and will continue to watch for signs of economic and financial stress that could put the Fed back on hold.

Energy prices suffered another leg down during the quarter while U.S. gross domestic product (GDP) and inflation statistics will likely, once again, come in on the low side for the full year. Annual inflation statistics are widely expected to bounce higher by late spring 2016, as the sharp drop in energy prices from early 2015 fall out of the year-over-year numbers. Given continuing headwinds from various global trade factors, however, a best-case outcome for GDP growth in 2016 is likely to be another year of just muddling through. There is a clear divergence between the U.S. manufacturing sector (recession-like conditions) and service sector (decent growth conditions), which could point to more challenging and volatile economic results in the near term.

In past business cycles, challenging and uncertain underlying economic conditions often have accompanied weak risk-asset performance. During the current cycle, however, this connection seems to have been less relevant because financial asset prices have been driven higher by global central bank stimulus. Making fundamentals-based investment decisions in recent years often has been out of sync with the markets, as risk-asset prices were pushed higher simply by the widespread printing of money. Some portfolio managers who chose to take less risk in recent years due to below-target economic growth often were punished by the central bank-sponsored rise in risk-asset prices. Today, with the European Central Bank (ECB) and the Bank of Japan (BoJ) still providing significant monetary stimulus, risk-off trades could still be at risk of underperformance. However, risk-asset prices did not follow that pattern as closely in 2015, which raises the question: has something changed? The Fed has ended quantitative easing, but the totality of its actions have not meaningfully offset policies of the ECB and the BoJ.

Instead, central banks in emerging markets (EMCBs) could be the swing factor. Up until mid-2014, EMCBs were part of the stimulus actions via asset purchases. Since then, EMCBs have been withdrawing liquidity by selling assets, a policy shift large enough to possibly offset the asset purchases of central banks in the developed world. The change in central bank actions could result in a realignment of risk asset prices with economic fundamentals. In that scenario, the risk-asset price volatility in 2015 could become even more pervasive in 2016. It may well be that reserve conditions in emerging markets will finally neutralize the ability of global central banks to keep pushing asset prices higher.

Domestic economic indicators showed mixed results throughout the fourth quarter. On the plus side, U.S. nonfarm payrolls increased by 271,000 in October, far exceeding expectations and helping to quell worries that the pace of employment growth was slowing. Overall, housing data and consumer confidence were positive as well. Although there was a slight downward revision to the third-quarter GDP estimate 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 remained low. Conversely, U.S. Services Purchasing Managers’s Index (PMI) business activity and manufacturing indicators continued to signal areas of weakness. While more recent U.S. economic indicators were favorable, these could be offset by continued weakness in China, Europe, and emerging market economies, and by subsequent volatility in the equity and commodity markets.

Within the Fund

For the fourth quarter of 2015, Delaware Extended Duration Bond Fund (Institutional Class shares and Class A shares at net asset value) underperformed its benchmark, the Barclays U.S. Long Corporate Index. The following points highlight the larger performance contributors and detractors during the quarter.

Contributors:

  • Strong security selection within industrials and utilities benefited relative performance. An overweight allocation to financials and underweight allocation to industrials also benefited performance.
  • An underweight to the energy sector benefited relative performance as oil prices fell to new lows amid underlying global growth concerns and continued oversupply.
  • The Fund’s noncorporate credit holdings returned 0.36% and represent positions not held by the benchmark, including municipal and quasi-sovereign debt. Build America Bonds exposure was a key driver to this outperformance, driven by holdings such as Chicago O’Hare International Airport and general obligation bonds of Texas and California. However, there were notable underperforming issues within noncorporates, including state-owned electric utility Saudi Electric.
  • The Fund’s position in bank loans outperformed the benchmark, but exposure to the sector was not material to the overall performance of the Fund.

Detractors:

  • Interest rate futures, which we use to manage the Fund’s overall portfolio duration, hampered Fund performance during the period.
  • Below-investment-grade exposure detracted from performance, as risk premiums continued to increase during the quarter. We reduced the Fund’s exposure to the sector dramatically during the year and continued to reduce exposure throughout the fourth quarter, but the remaining holdings negatively affected performance.
  • Emerging markets exposure detracted from performance, as commodity price volatility and global growth concerns continued to weigh heavily on these markets. We continued to reduce exposure throughout the quarter.
  • The sectors that detracted the most from relative performance for the period included communications, technology, and insurance.

Outlook

We expect the U.S. economic expansion to continue at a modest pace, with the upside and downside risks to our growth forecast 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 that currency volatility will remain a central theme in 2016. Manufacturing likely will continue to experience headwinds as global demand remains under pressure. We believe the path to the Fed’s target of 2% inflation level will be challenged — particularly in the second half of the coming year.

Moving into 2016, we expect that reduced Treasury supply, coupled with low inflation and competitively low global yields, should help limit upside surprises for domestic interest rates. Finally, we think the impact of central banks’ 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.

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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)-1.28%-4.77%-4.77%1.95%7.52%8.02%7.98%09/15/1998
Class A (at offer)-5.69%-9.04%-9.04%0.39%6.52%7.52%7.69%
Institutional Class shares-1.22%-4.55%-4.55%2.20%7.79%8.30%8.24%09/15/1998
Barclays Long U.S. Corporate Index-0.97%-4.61%-4.61%1.36%6.29%6.18%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 Long U.S. Corporate 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)1.00%
Class A (Net)0.96%
Institutional Class shares (Gross)0.75%
Institutional Class shares (Net)0.71%

Net expense ratio reflects a contractual waiver of certain fees and/or expense reimbursement from Nov. 27, 2015 through Nov. 28, 2016. Please see the fee table in the Fund's prospectus for more information.

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 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.

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