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Delaware Diversified Income Fund Quarterly commentary December 31, 2016

Overview

The Bloomberg Barclays U.S. Aggregate Index recorded a negative return for the fourth quarter, with higher-quality AAA-rated bonds outperforming lower-rated investment grade credit tiers within that index on a total return basis. However, based on excess return, BBB-rated credit significantly outperformed. Although most broad-market fixed income indices produced negative returns, high yield corporate bonds were positive performers for the period.

U.S. economic indicators were generally stronger, with the Citigroup Economic Surprise Index rising to end 2016 in positive territory. Jobless claims, which have averaged about 263,000 a month for the past year, remained low while nonfarm payrolls, which have averaged about 200,000 a month since 2011, fell to about 176,000 during the quarter. On the inflation front, core personal consumption expenditures (or PCE, the Federal Reserve’s preferred inflation gauge) declined slightly to 1.6% year-over-year. Meanwhile, personal income and spending remained subdued, with both metrics falling during the quarter. Until personal and wage-and-salary income growth accelerates, consumer inflation is likely to remain muted. Notably, the National Federation of Independent Business (NFIB) Small Business Optimism Index rose following the U.S. election.

The global economy stands at an important crossroads. As financial markets trade on unrealized expectations for faster growth, it is appropriate to question whether reality will eventually intervene. Would even the most optimistic scenario for the implementation of tax and infrastructure (that is, fiscal) policy measures make enough of an impact to offset the sizable and longstanding headwinds to global growth that are centered on aging populations, lower productivity, a massive debt overhang, and a general lack of global demand? Anything more than a slightly marginal increase in U.S. and global gross domestic product (GDP) seems unrealistic to us.

Equally important, how do investors factor in the high level of uncertainty arising from implementation-related challenges for the Trump administration? These challenges include the incoming president’s penchant for unpredictability; the extent to which he and the Congress are able to cooperate; the president-elect’s prioritization of growth-restricting global trade–related actions versus his growth-supportive fiscal plan; and the potential for any growth programs to be driven by a surge in government debt. Given current structural obstacles, it seems unlikely that a debt-financed plan can be a long-term positive for economic growth unless the debt-financed actions add substantively to U.S. and global productivity. History reminds us that uncertainty is generally bad for financial assets, so a measure of caution along with the current serving of hope seems appropriate, in our view.

Within the Fund

Delaware Diversified Income Fund (Institutional Class shares and Class A shares at net asset value) posted a negative return but outperformed its benchmark, the Bloomberg Barclays U.S. Aggregate Index, for the fourth quarter of 2016.

Contributors:

  • An underweight to U.S. Treasurys compared to the benchmark index contributed to the Fund’s performance during the quarter. As interest rates rose significantly during the quarter, with the 10-year U.S. Treasury yield increasing by 0.85 percentage points, the Fund’s underweight to Treasurys benefited performance as duration-sensitive securities experienced negative returns.
  • The Fund’s allocation to bank loans, a sector not represented in the benchmark index, contributed to performance during the quarter. Bank loans, which are traditionally used to buffer the effect of rising interest rates, performed well during the quarter.
  • Investment selection within mortgage-backed securities, specifically allocations to nonagency collateralized mortgage obligations and to credit risk transfer deals (which provide credit exposure to the U.S. residential mortgage market), contributed to performance during the period.

Detractors:

  • Yield curve positioning within investment grade corporates, specifically the Fund’s positioning along the intermediate part of the curve, detracted from performance, as the yield curve steepened and yields moved significantly on this part of the curve.
  • The Fund’s allocation to emerging markets, which is a sector not represented in the benchmark index, detracted from Fund returns during the quarter. The surprise outcome of the U.S. presidential election caused volatility in many emerging markets and caused those bonds to trade lower.

Outlook

As we assess the investment outlook and develop strategy, we are focused on many of the same issues as in 2016. The effectiveness of monetary policies in the developed world appears to be declining and fiscal policy is moving to the forefront. We take a favorable view of corporate tax reform, which could lead to a more sustainable rise in economic growth rates; however, a completed bill may arrive too late to have a material impact on growth in 2017. Our credit team has detected signs that corporate fundamentals are stabilizing at a time when business outlooks are improving along with consumer confidence. We believe continued gains in global services and manufacturing data adds support to this thesis. We will be watching closely for a continuation of these trends.

However, we are hesitant to extrapolate the good news too far into 2017. The renewed strength in the U.S. dollar presents headwinds that are not specific to the United States but that could lead to a tightening of global financial conditions. Dollar strength will weigh on U.S. exports, which may result in weaker corporate profits. Continued strength of the dollar could also drive an increase in Chinese capital outflows during a time when China is walking an economic “high wire” in trying to balance the need for short-term growth against a worrisome long-term debt problem. Furthermore, emerging economies that have relied heavily on funding in U.S. dollars over the past several years could experience challenges.

As in late 2015, markets are currently anticipating multiple rate hikes by the Fed in the upcoming year. The Fed’s “dots” forecast of three such moves in 2017 appears to be impacting market expectations as well. A new era of Fed hikes could begin this year, but as we noted last quarter, nothing can be taken for granted in a world burdened by debt and subpar growth trends. The global search for yield likely will continue, but it may not be enough to support risk premiums for credit that are inside long-term averages. Avoiding idiosyncratic risks should provide the backdrop for our active, fundamental research-based approach to help navigate these challenging times.

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

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.

The NFIB Small Business Optimism Index is a survey asking small business owners a battery of questions related to their expectations for the future and their plans to hire, build inventory, borrow, and expand.

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 (12/31/2016)
Current
quarter
YTD1 year3 year5 year10 yearLifetimeInception
date
Class A (NAV)-2.42%3.56%3.56%2.47%2.55%5.31%6.68%12/29/1997
Class A (at offer)-6.82%-1.06%-1.06%0.91%1.61%4.83%6.42%
Institutional Class shares-2.35%3.94%3.94%2.73%2.83%5.57%6.48%10/28/2002
Bloomberg Barclays U.S. Aggregate Index-2.98%2.65%2.65%3.03%2.23%4.34%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.

Bloomberg Barclays U.S. Aggregate 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)0.89%
Class A (Net)0.89%
Institutional Class shares (Gross)0.64%
Institutional Class shares (Net)0.64%
Share class ticker symbols
Institutional ClassDPFFX
Class ADPDFX
Class CDPCFX
Class RDPRFX
Class R6DPZRX

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.

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.

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 experience portfolio turnover in excess of 100%, which could result in higher transaction costs and tax liability.

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