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Delaware Limited-Term Diversified Income Fund Quarterly commentary June 30, 2015

Overview

During the second quarter of 2015, fixed income markets experienced significant setbacks as rates rose across the yield curve — both in Treasurys and other global sovereigns — and spreads widened in several key sectors. Intermediate and long maturities led the rate rise as liquidity was a problem at times, especially for sovereign bonds. With regulatory blockages, a shrinking repo market, smaller capital commitments at many key trading counterparties, and ongoing market volatility, liquidity will likely continue to be a periodic challenge. Past experience shows that liquidity-based market setbacks tend to be sharp but brief without the sustained impact of deteriorating fundamentals. During the quarter, the Federal Reserve pointed to slightly more upbeat growth conditions and relatively balanced risks while seemingly heading toward an initial rate increase in the second half of 2015. This “most likely” Fed scenario still seems potentially off track since it would come despite recent U.S. dollar strength, lower commodity prices, and below-target inflation statistics. Rarely has the Fed begun to tighten in the face of these factors.

While the “liftoff date” for the initial rate hike has been the policy question of the year, the trajectory of any increases is quickly becoming the more important focus. It seems highly probable that the Fed will raise rates in an unusually gradual way during its next tightening cycle. The Fed’s caution may be based on the continued struggle to break out of the “muddle along” 2%-plus recovery, but it may also be driven by its recognition that other factors have already started the tightening process, such as the stabilization of its balance sheet and the strength of the U.S. dollar. Recently, economic forecasters have begun talking about U.S. growth accelerating into the 2.0–2.5% range in the second half of 2015. If those projections turn out to be accurate, the Fed has good reason to be cautious. The Fed’s own forecasts should also be a warning, as members of the Federal Open Market Committee (FOMC) recently reduced their 2015 gross domestic product (GDP) forecast to a range of 1.8–2.0% growth, while sticking with their 2015 inflation outlook of 0.6–0.8%.

Domestic economic indicators were mixed during the quarter. In the labor market, initial jobless claims remained below 300,000 and manufacturing activity surpassed consensus expectations. However, the weak Purchasing Managers’ Index (PMI) number in June raised the possibility of a loss of momentum entering into the third quarter. Conversely, consumer demand and housing statistics provided a boost in sentiment. Those positives were further supported by the U.S. Commerce Department’s revised first-quarter GDP estimate showing a 0.2% contraction (compared with the previous estimate’s 0.7% drop), perhaps supporting speculation that port delays and harsh winter weather had affected growth. Second-quarter data showed the economy expanding again, but at a pace softer than forecasters were anticipating following the winter slowdown. Supporting a cautionary tone, core inflation rose less than forecasted during the second quarter, a sign that it may take more time to meet the Fed’s inflation goal.

Although the June FOMC meeting took on a more dovish tone, the Fed nonetheless maintained its policy target range of zero to 0.25%. Also, the FOMC was more specific in describing its criteria for raising rates: “further improvement in the labor market” (even though the unemployment rate is now back to spring 2008 levels) and convincing evidence that inflation (which has been running below target) is heading back to 2%.

During the second quarter of 2015, yields on 10-year Treasurys rose from 1.92% to 2.35%, and yields on 2-year Treasurys rose from 0.56% to 0.65%. Rates rose steadily during the quarter, at times with great volatility. The 3-month T-bill / 10-year T-note curve steepened 45 basis points to 2.34% by the end of the quarter (a basis point equals a hundredth of a percentage point). The 1-month London interbank offered rate (Libor) remained essentially unchanged for the period, ending the quarter at 0.18%. (Data: Bloomberg.)

The Barclays U.S. Aggregate Index recorded a negative return in the second quarter as even the poor returns from Treasury securities turned out to be better than those from corporate bonds. Financials were stronger than other investment grade sectors, with utilities significantly underperforming. U.S. dollar emerging market bonds and asset-backed securities (ABS) produced modest positive returns for the period.

Within the Fund

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

Among the primary drivers of performance:

  • The Fund’s continued overweight in investment grade corporate bonds detracted from relative performance due to spread widening in the corporate sector.
  • Yield curve positioning also detracted, as the Fund’s intermediate and longer-duration holdings underperformed.
  • Individual security selection contributed to relative performance during the quarter.
  • The Fund’s overweight positions in short floating-rate ABS were a positive for performance and served to anchor the overall portfolio.

Outlook

Our broad investment concern is the current disconnect between below-trend global economic growth and the quantitative easing–induced rise in financial asset values. Though the ultimate reconnection could most likely come through a sharp decline in asset values (fundamentals should prevail), predicting its timing is beyond difficult and carries its own risks. While bond markets will certainly feel the adjustment, stock markets will probably be at the center of the move.

Interestingly, a number of “outside the box” market factors are warning that this decline in asset values could come in the near future. In no particular order, U.S. equity markets have recently seen a meaningful reduction in the level of new highs while an old — but frequently worthy — indicator shows that the Dow Jones Industrial Average recently reached new highs while transports were making new lows. “Confirmation” is critical in momentum-based markets and now may be waning. Also, while the Shanghai Stock Exchange Composite Index has sustained an almost 20% pullback after a historic rally, the Japanese yen recently broke through key support and could be headed to much weaker levels. The connection here, of course, is that economic growth in China (and Asia as a whole) would be hurt by a further sharp decline in the yen. Finally, despite the apparent bounce in U.S. economic statistics over the past two months, a “relative to expectations” statistic, the Citigroup Economic Surprise Index, is pointing to weakness in U.S. data. In this very uncertain and volatile market environment, our goal is to position client portfolios with prudent levels of risk — levels that are reasonable and sustainable during market dislocations so that we can respond to market setbacks not by panic selling, but by opportunistic buying.

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

The Purchasing Managers’ Index or PMI, published by Markit Group, measures the health of the manufacturing sector.

The Dow Jones Industrial Average is an often-quoted market indicator that comprises 30 widely held blue-chip stocks.

The Shanghai Stock Exchange Composite Index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange.

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 (06/30/2015)
Current
quarter
YTD1 year3 year5 year10 yearLifetimeInception
date
Class A (NAV)-0.52%0.71%0.72%0.04%1.40%3.40%5.08%11/24/1985
Class A (at offer)-3.23%-2.05%-2.02%-0.87%0.84%3.11%4.98%
Institutional Class shares-0.48%0.78%0.87%0.19%1.55%3.56%4.36%06/01/1992
Barclays 1-3 Year U.S. Government/Credit Index0.13%0.72%0.93%0.94%1.17%2.83%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, 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.

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