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

Overview

In our fourth quarter commentary, we called for “more, not less, volatility in 2015.”And during the first quarter of 2015, the markets delivered that volatility — right out of the gate. Interest rates dropped significantly during January before retracing and consolidating this yield change during February and March. Intermediate and long maturities led the rate decline, while corporate credit returns benefited from a combination of fixed-rate bond duration and an attractively priced yield advantage.

During the quarter, the Federal Reserve removed its previous reference to “patience” with regard to the timing of a first rate increase. Based on both its words and its “dots,” the Fed seems headed toward a rate increase regime that starts in the second half of 2015 and progresses very gradually thereafter. The Federal Open Market Committee (FOMC) made it clear, however, that its dropping the pledge to be “patient” does not guarantee a near-term move in rates. Rather, it will continue to monitor economic conditions using a data-dependent process. Of course, even that scenario would almost certainly diverge from monetary policy overseas.

As global central banks implement quantitative easing–like policies and create massive liquidity, financial assets could continue to benefit. Portfolio managers must strike a strategic balance that acknowledges the wide dispersion of potential outcomes resulting from weak economic growth and almost nonexistent inflation, but also with strong underlying support for financial asset prices.

Economic indicators in the United States showed mixed results throughout the first quarter of 2015, suggesting that domestic economic growth moderated. Data for employment and manufacturing were solid, but consumer demand and housing showed weakness. Fourth quarter gross domestic product (GDP) growth came in unrevised at 2.2%, according to the U.S. Commerce Department. Though core inflation was slightly higher during the first quarter, headline prices were lower as falling energy prices provided an important dampening effect.

During the first quarter of 2015, yields on 10-year Treasurys fell from 2.17% to 1.92% while yields on 2-year Treasurys declined from 0.67% to 0.56%. By the end of the quarter, the 3-month T-bill / 10-year T-note curve flattened by 13 basis points to 1.89%. The 1-month London interbank offered rate (Libor) remained essentially unchanged for the period, ending the quarter at 0.17%. (Data: Bloomberg.) Finally, the Barclays U.S. Aggregate Index recorded a strong return in the first quarter as corporate bonds (especially those of lower quality) and longer-duration sectors led the way. Given the shift in the Treasury yield curve, short-to-intermediate-focused sectors produced lower nominal returns while BBB-rated corporates, high yield corporate bonds, and emerging market debt produced strong excess returns. (Note: One basis point equals a hundredth of a percentage point.)

Within the Fund

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

  • The Fund’s underweight position in Treasury securities was a moderate positive contributor to relative returns, as Treasurys underperformed both the index and the credit sector.
  • The Fund’s continued overweight in investment grade corporate bonds benefited relative performance during the quarter. Corporate bond credit spreads narrowed over the period, and individual security selection was a strong contributor to performance as the Fund’s holdings in the sector returned 2.06% versus 0.70% for the credit sector in the index. The longer duration exposure, in addition to our down-in-quality bias, had positive effects on performance.
  • The Fund’s substantial holdings in floating-rate asset-backed securities (ABS) detracted from performance during the period, as shorter-duration bonds underperformed long bonds. Commercial mortgage-backed securities (CMBS) had a slight positive effect on relative performance.
  • High yield, bank loans and emerging market debt all recovered from a disappointing fourth quarter to contribute positive performance for the quarter. However, this was offset by high yield credit default swaps held in the Fund as a hedge to risky assets. Investments in bank loans showed more moderate, albeit still negative, results.

Outlook

Among the most important — and unresolved — economic questions facing investors is whether deflation will be a bigger risk than inflation over the next several years. That’s because despite massive money-printing efforts in recent years by key central banks, little progress has been made toward hitting inflation targets. We believe something fundamental is at work here, and critically, it could not come at a worse time.

The global debt overhang is challenging enough, but servicing debts during a period of deflation places substantially more pressure on the debtor. Sourcing the needed free cash becomes, by definition, much more difficult. If the debts are owed in other currencies, even governments may not be able to print their way out of the problem. Default risks would rise and could be the most fundamental source of performance challenges in risk assets. Plenty of optimistic and pessimistic market scenarios exist for the near term, but we will strive to maintain our balanced, research-driven, risk-managed approach, which we believe can help us maneuver around the challenges to come.

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

Bond ratings are determined by a nationally recognized statistical rating organization (NRSRO).

Per Standard & Poor’s credit rating agency, bonds rated below AAA are more susceptible to the adverse effects of changes in circumstances and economic conditions than those in higher-rated categories, but the obligor’s capacity to meet its financial commitment on the obligation is still strong. Bonds rated BBB exhibit adequate protection parameters, although adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments. Bonds rated BB, B, and CCC are regarded as having significant speculative characteristics, with BB indicating the least degree of speculation of the three.

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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 (03/31/2015)
Current
quarter
YTD1 year3 year5 year10 yearLifetimeInception
date
Class A (NAV)1.24%1.24%1.87%0.65%1.53%3.61%5.14%11/24/1985
Class A (at offer)-1.54%-1.54%-0.90%-0.28%0.97%3.31%5.04%
Institutional Class shares1.27%1.27%2.15%0.80%1.70%3.76%4.43%06/01/1992
Barclays 1-3 Year U.S. Government/Credit Index0.59%0.59%1.12%0.97%1.35%2.94%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)0.92%
Class A (Net)0.82%
Institutional Class shares (Gross)0.67%
Institutional Class shares (Net)0.67%

Net expense ratio reflects a contractual waiver of certain fees and/or expense reimbursement from April 30, 2014 through April 30, 2015. 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