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Delaware Limited-Term Diversified Income Fund Quarterly commentary December 31, 2015

Overview

Financial markets finally took the Federal Reserve 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’ 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 divergence between the U.S. manufacturing (recession-like conditions) and service (decent growth conditions) sectors, 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 has been less relevant because financial asset prices have been driven higher by global central bank stimulus. Making fundamentally 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 (QE), but we believe 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 clearly part of the stimulus actions via asset purchases. Since then, EMCBs have been withdrawing liquidity by selling assets, a policy shift large enough to completely offset the asset purchases of central banks in the developed world. The change in central bank actions should 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 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, these could 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 rose from 2.04% to 2.27% while the initial Fed tightening helped to push 2-year Treasury yields up from 0.63% to 1.05%. The 3-month T-bill / 10-year T-note curve steepened by 6 basis points, to end at 2.10%. After the release of the minutes of the October Federal Open Market Committee (FOMC) meeting (which conveyed the sense that the majority of Committee members were prepared to raise rates at the December meeting), 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 performers for the period, with the U.S. corporate high yield sector lagging significantly.

Within the Fund

Delaware Limited-Term Diversified Income Fund (Institutional Class shares and Class A shares at net asset value) outperformed its benchmark, the Barclays 1–3 Year U.S. Government/Credit Index, for the fourth quarter of 2015.

The Fund’s overweight allocation to corporate bonds was the primary driver of performance for the period. Allocations in mortgage-backed securities (MBS), asset-backed securities (ABS), and emerging markets debt also were positive contributors, as these sectors outperformed the return of the benchmark. Meanwhile, exposures within high yield and bank loans detracted from relative performance.

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 see the Fed’s goal of raising rates four times in 2016 as 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 to limit upside surprises for domestic interest rates. Finally, the impact of central banks’ and sovereign wealth funds’ selling assets should not be underestimated or ignored.

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

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

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)-0.30%0.62%0.62%0.02%1.06%3.36%4.99%11/24/1985
Class A (at offer)-3.05%-2.14%-2.14%-0.90%0.50%3.08%4.89%
Institutional Class shares-0.27%0.77%0.77%0.17%1.21%3.52%4.27%06/01/1992
Barclays 1-3 Year U.S. Government/Credit Index-0.36%0.65%0.65%0.69%0.98%2.74%n/a

Returns for less than one year are not annualized.

Class A shares have a maximum up-front sales charge of 2.75% and are subject to an annual distribution fee.

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

Barclays 1-3 Year U.S. Government/Credit Index (view definition)

Expense ratio
Class A (Gross)0.93%
Class A (Net)0.83%
Institutional Class shares (Gross)0.68%
Institutional Class shares (Net)0.68%

Net expense ratio reflects a contractual waiver of certain fees and/or expense reimbursement from April 29, 2015 through April 29, 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 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.

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 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.

Diversification may not protect against market risk.

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

Not FDIC Insured | No Bank Guarantee | May Lose Value