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Delaware Diversified Income Fund Quarterly commentary March 31, 2017

Overview

A broad investment rally that started soon after the 2016 presidential election continued into the first quarter of 2017. The hope of a friendlier environment for US business, as well as a rebound in economic growth and inflation, fueled the rally. It seems to us that the seeds of the rally were sown in the reactions by central banks and the Organization of the Petroleum Exporting Countries (OPEC) to the commodities and capital markets meltdowns of late 2015 and early 2016. Central banks applied significant monetary stimulus to banks and markets, and OPEC set the stage for a production freeze and quota to support oil prices. Improvement in economic activity, earnings, and inflation has accompanied the market rally. Many of the improvements have been small, though they have come off troubling low levels. The Citigroup Economic Surprise Index, which measures the difference between economic release forecasts and their actual outcome, has shown surprising strength across the globe.

Credit analysts have been heartened by a return to revenue and earnings growth for US corporations as well. The S&P 500® Index companies had entered into a small earnings and revenue recession in late 2015 and early 2016. Company results for the third and fourth quarters of 2016 confirm that top and bottom line momentum has picked up again, and they have restored earnings to year-over-year gains.

Additionally, central banks’ steps to provide liquidity to both capital markets and international banks led to a significant opening up of the financial markets. High yield companies that were under financial stress had already taken steps to either work out debt, cut costs, cut dividends, or sell assets. Now they had access again to the capital markets and used that environment to term out debt or increase liquidity. As a result, default rates declined in the third and fourth quarter of 2016.

After a strong rally in 2016 (after the central bank and OPEC actions described above) yield premiums in the fixed income markets continued to decline in the first two months of 2017. Events late in the quarter helped reduce the market improvements. The US Federal Reserve raised the federal funds rate by a quarter percentage point to a new range of 0.75% to 1.00%. Additionally, some volatility was created around the failed vote in the US House of Representatives to repeal and amend the Affordable Care Act (ACA). While traditional high yield bonds retraced most of their yield premium decline, levered loans retained much of their progress. The emerging market sectors also did well, and local currency bond performance surprised investors in spite of President Trump’s threats to rejigger trade terms with these countries.

Within the Fund

What worked in the Fund:

  • The Fund’s allocation to emerging market investments, a sector not represented in the Fund’s benchmark, the Bloomberg Barclays US Aggregate Index, contributed to returns for the quarter. Emerging market bonds were one of the strongest-performing sectors during the first quarter.
  • The Fund’s allocation to high yield bonds, a sector not represented in the benchmark, contributed to returns for the quarter. Yield premiums rallied early in the first quarter as fourth-quarter reports on economics and earnings improved. After a setback in early March when oil prices declined and the US House failed to bring healthcare reform legislation to a vote, high yield bond prices rallied back.
  • An overweight allocation and security selection in investment grade financials contributed to the Fund’s returns during the quarter. Improving balance sheets and deleveraging led to strong performance in the banking sector. We continue to favor entities from the United States, United Kingdom, Switzerland, and the Netherlands.

What did not work in the Fund:

  • Investments in fixed-rate mortgage-backed securities (MBS) detracted from returns as high-coupon agency pass-through securities underperformed the benchmark in the bullish flattening curve environment.
  • A hedge on German interest rates detracted from returns for the quarter. We thought that German rates would react faster to the potential increase in global growth and inflation; however, European political volatility negated this reaction.

Outlook

The Fund has an income advantage over the benchmark due to its exposure to the corporate and structured product sectors. In the first quarter, this income advantage averaged more than a percentage point. Central bank actions to keep rates low, and to buy corporate bonds, have created a favorable environment for moving away from US Treasury investments. We expect to keep this credit exposure and income advantage in the Fund in the near term. A combination of possible Trump stimulus, and a favorable business environment, will compete against a higher US interest rate environment, and a likely relentless rise in the US dollar in 2017. We will watch these competing forces very closely.

The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock 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 delawarefunds.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 (06/30/2017)
Current
quarter
YTD1 year3 year5 year10 yearLifetimeInception
date
Class A (NAV)2.00%3.52%2.07%1.99%2.54%5.37%6.69%12/29/1997
Class A (at offer)-2.62%-1.19%-2.54%0.44%1.60%4.89%6.44%
Institutional Class shares1.94%3.53%2.33%2.20%2.78%5.63%6.51%10/28/2002
Bloomberg Barclays U.S. Aggregate Index1.45%2.27%-0.31%2.48%2.21%4.48%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 US 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 bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have 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 US 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