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Delaware Extended Duration Bond Fund Quarterly commentary March 31, 2016

Overview

The fixed income market aggressively sold risk assets over the first half of the quarter and then turned on a “Draghi dime” and bought risk assets through the end of the period. The first wave of risk-buying in late February gained traction after European Central Bank (ECB) President Mario Draghi made it clear that the ECB would not hesitate to further loosen monetary policy and Federal Reserve Chairwoman Janet Yellen mentioned tightening U.S. financial conditions and increased global risks. Risk assets received an additional boost in March after the ECB acted on Draghi’s proposals and Yellen amplified her dovish comments. Significant swings in oil prices and the U.S. dollar contributed to volatility as well.

For the first quarter, the Barclays U.S. Aggregate Index recorded a positive return, with lower-quality bonds outperforming the higher-rated investment tiers within the index. Although most broad-market fixed income indices produced solid returns, non-U.S. Treasurys and emerging market bonds were the strongest performers, with the asset-backed securities (ABS) and mortgage-backed securities (MBS) sectors lagging.

Investment grade bond markets witnessed a dramatic recovery in risk premiums and sentiment during the quarter, driven by the rally in oil prices back into the low $40s from a decade bottom of $28, continued global central bank accommodation, and better domestic economic data relative to expectations (measured by the improvement in the Citigroup U.S. Economic Surprise Index). However, downside risks remain and we expect credit risk premiums to remain volatile due to a (still) heavy new-issue supply calendar, new realities in terms of market liquidity, further global growth concerns, and commodity price uncertainty. Investment grade bond supply ended the quarter at $360 billion, slightly ahead of last year’s record pace (the first quarter of 2015 was the second highest on record) but still historically high as the mergers-and-acquisitions funding pipeline from 2015 remains intact (source: Bank of America).

In March, U.S. gross domestic product (GDP) growth for the fourth quarter of 2015 was revised upward to a 1.4% annualized pace due to a jump in consumer spending. However, corporate profits fell 7.8% during the quarter, the biggest decline since the first quarter of 2011 (-9.2%). Among the more positive trends, jobless claims, which have averaged about 275,000 for the past year, suggest continued strength in the pace of hiring.

With investors in perpetual Fed-watch mode, recent statements by Fed officials (other than Yellen) that appear to lean more toward a near-term tightening have been a source of uncertainty. This leaning may be the result of recent signs that inflation expectations are finally approaching the Fed’s 2% target. Though the last official Fed communication suggested two additional quarter-percentage-point increases in the federal funds rate this year, the markets are discounting only one increase in the fourth quarter of 2016. We are inclined to favor the market’s “one increase” view but believe it could come as early as summer.

Within the Fund

For the first quarter of 2016, Delaware Extended Duration Bond Fund (Institutional Class shares and Class A shares at net asset value) underperformed its benchmark, the Barclays Long U.S. Corporate Index. The following highlights the larger performance contributors and detractors to Fund performance during the period:

A rally in risk premium and sentiment during the latter half of the quarter erased a weak start to the year for long-term investment grade corporate bonds. The Fund’s conservative positioning within investment grade corporates underperformed the benchmark, which returned 6.83% for the quarter. The strong performance of investment grade corporate bonds was driven by a sharp decline in Treasury yields. For the quarter, yields on 10-year Treasurys fell by 49 basis points while 30-year Treasury yields fell 40 basis points, resulting in a 9-basis-point steepening of the 10-year through 30-year portion of the curve. After initially widening by more than 50 basis points, credit spreads in the long-term corporate bond market finished 3 basis points tighter on the quarter, at 225 basis points.

The strongest-performing sectors within the index were basic industry, communications, and consumer noncyclical, which returned 10.5%, 8.4%, and 8.1%, respectively. The Fund’s underweight to each of the sectors detracted from relative performance. Strong security selection in consumer noncyclicals offset the underweight and the sector was additive to relative performance.

Financials, and specifically banks, were the poorest performers. Companies in those groups were negatively affected by a selloff in Yankee bonds — U.S. dollar debt issued by European companies — after European banks reported lower earnings and received negative headlines. Weak security selection and an overweight to the sector detracted from relative performance as well. Meanwhile, the electric sector provided the largest contribution to the Fund’s return, as an overweight allocation and strong security selection benefited total return and performance relative to the index. The electric sector was up 7.1%, outperforming the index as a whole.

Out-of-index investments in Treasury securities (approximately 6%) and municipal bonds (approximately 1%) were positive contributors to total return, although each underperformed the benchmark. A small investment in high yield corporate bonds (approximately 1%) was negative for total return but was offset by positive performance from another small investment in emerging markets bonds (approximately 1%). Interest rate futures, which we use to manage the Fund’s overall portfolio duration, were additive to total return during the period.

Outlook

Fundamentals within nonfinancials remain under pressure as rising leverage and increased use of financial engineering via accommodative policy have deteriorated credit metrics. Many multinational companies are expecting top- and bottom-line pressure in the upcoming quarter from the strength of the U.S. dollar. A decline in earnings per share driven by a decline in revenue would be a slight credit negative, as it implies a modest deceleration in growth, although we do not expect a meaningful move in spreads or credit quality, as our outlook for growth remains similar to what we’ve seen over the past few years (approximately 2%) which is generally supportive of credit. Technicals remain mixed as heavy new-issue supply has prevented secondary spreads from tightening and overall liquidity remains constrained, while institutional and foreign demand should continue to provide support to the asset class. Furthermore, the ECB’s purchase of corporate bonds should drive more European investors to the U.S. markets in search of yield as well as push some issuance overseas in the form of reverse Yankee issuance.

The recent moves in investment grade bond credit valuations (and the commodity space in particular) have been volatile, which we have seen become the new norm in capital markets. Fundamentally, signals of sluggish global growth have not changed since the beginning of the year and as a result, the large swings in bond prices we have witnessed recently are likely due to technicals (predominantly the lack of liquidity on Wall Street causing incredible price discovery, along with short-coverings). We believe this kind of volatility may continue for the foreseeable future, regardless of any material changes in fundamental or macroeconomic views. For the year, we believe investment grade credit could generate positive total and excess returns, but that volatility will remain and may create attractive entry points. We believe our credit portfolios are positioned to take advantage of such opportunities.

The Barclays U.S. Aggregate Index is a broad composite that tracks the investment grade domestic bond market.

The Citigroup Economic Surprise Index is a rolling measure of beats and misses of indicators relative to consensus expectations.

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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 (03/31/2016)
Current
quarter
YTD1 year3 year5 year10 yearLifetimeInception
date
Class A (NAV)5.38%5.38%-2.79%3.80%8.43%8.89%8.18%09/15/1998
Class A (at offer)0.56%0.56%-7.18%2.20%7.43%8.39%7.90%
Institutional Class shares5.45%5.45%-2.41%4.06%8.71%9.17%8.45%09/15/1998
Barclays Long U.S. Corporate Index6.83%6.83%-1.34%4.26%7.65%7.23%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 derivatives 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