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Delaware Extended Duration Bond Fund Quarterly commentary December 31, 2016

Overview

The investment grade credit market posted its weakest quarter on a total return basis since mid-2015 as the massive rate selloff following the U.S. election overwhelmed a modest narrowing in credit spreads. Donald Trump’s surprising victory and the Republican sweep of Congress not only took pollsters and the market by surprise, but also changed market expectations, driving the U.S. dollar to its highest level since December 2002 and 10-year Treasury rates up by 59 basis points (a basis point equals one hundredth of a percentage point). Expectations for a more aggressive Federal Reserve, combined with the fiscal policy implications of a new government regime, were the main drivers. The Fed’s rate-setting Federal Open Market Committee (FOMC) did not disappoint, raising the federal funds rate by 0.25 percentage points in December and also accelerating the pace of policy normalization by raising its expectations for 2017 to three rate hikes, up from two in its September “dot plot.” Conversely, the European Central Bank (ECB) sent a mostly dovish message by extending its quantitative easing program through the end of 2017 while reducing the monthly pace of purchases to 60 billion euros, noting that the program’s size or duration could be expanded as needed.

The Bloomberg Barclays U.S. Corporate Investment Grade Index returned -2.83% for the quarter, outperforming duration-matched Treasury debt by 185 basis points. Energy and metals/mining were the strongest performing sectors, driven by a strong commodity price rally, with oil up 10.2% and iron ore up more than 29% for the period. The Organization of the Petroleum Exporting Countries (OPEC) surprised most critics with an agreement to cut production for the first time since 2008, pushing oil prices higher and spreads tighter across all energy subsectors. Interest rate-sensitive sectors such as banks and insurance also outperformed, benefiting from the surge in rates along with favorable total loss-absorbing capacity (TLAC) resolution for domestic banks. Longer-duration sectors such as utilities and rails underperformed for the quarter, while the media/telecom space came under pressure from AT&T’s surprise deal to acquire Time Warner Inc. for $109 billion.

Supply for the quarter declined 15% from last year, to $259 billion. However, year-to-date totals for 2016 set another record at $1.3 trillion, up 4% from the previous year’s record amount. Estimates for 2017 call for lower gross and net supply in the $1.06 trillion area, as higher rates and a smaller mergers and acquisitions (M&A) pipeline limit issuance (source: Bank of America). We believe limited supply should be a positive technical factor for secondary market prices. In addition, the potential for overseas cash repatriation, as part of broader corporate tax reform initiatives, could also reduce issuance needs, further supporting market technicals.

The global economy and financial markets stand at an important crossroads. As financial markets trade on unrealized expectations for faster growth, we believe it’s 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.

Within the Fund

During the fourth quarter of 2016, Delaware Extended Duration Bond Fund (Institutional Class shares and Class A shares at net asset value) underperformed its benchmark, the Bloomberg Barclays Long U.S. Corporate Index.

Rates increased 0.40 to 0.80 percentage points across the curve during the quarter, in part due to the U.S. presidential election outcome, a Fed rate hike, and improving global economic data. Adding stress to rates was the Fed’s latest dot plot projecting three rate hikes for 2017 instead of two. Investment grade credit spreads tightened by approximately 0.10 percentage points during the fourth quarter. The long corporate market generated excess returns of 4.36% as buyers of yield continued unabated.

The financial sector significantly outperformed the other major sectors as banks continued a post-Brexit rally, and volatility around Deutsche Bank’s $14 billion fine assessed by the U.S. Department of Justice was settled for a more manageable $7.2 billion. The Fund’s overweight position in financials combined with strong security selection benefited performance. The Fund’s financial holdings returned -3.61%, compared to the benchmark’s financial holdings return of -3.75% for the quarter. The Fund held an average 24% exposure to the financial sector during the quarter, of which 17% was to banking. The leading performers in this sector were Credit Suisse Group AG, Wells Fargo & Co., and HSBC Holdings.

Industrials continued to represent the largest exposure to investment grade credit in the Fund’s portfolio, averaging 52%. Although industrials represents the largest sector in the Fund, we are significantly underweight compared to the benchmark. Commodity issuers such as Plains All American Pipeline, Energy Transfer Partners, and Enbridge were some of the stronger-performing holdings in the Fund. Chemical holdings, including Potash and Methanex, also outperformed the broader market. Good security selection within consumer cyclicals aided performance, while consumer noncyclicals detracted from performance, in part due to exposure to higher-quality names such as SC Johnson & Son.

Utilities, which tend to underperform during of periods of rising rates, averaged 16% of the Fund’s portfolio for the quarter. While the Fund was overweight utilities, our security selection enabled the Fund’s utility names to outperform those in the index, returning -5.83% versus -5.99%.

Outlook

As we assess the investment outlook and develop our strategy for 2017, we are focused on many of the same talking points as in 2016. The effectiveness of monetary policies in the developed world appears to be declining, and fiscal policy is moving to the forefront as expectations are high for the incoming Trump administration. With that said, we take a favorable view on corporate tax reform, which could lead to a more sustainable rise in potential gross domestic product (GDP) growth; however, a completed bill may arrive too late in the year to have a material impact on growth in 2017. Our credit team has observed signs that corporate fundamentals are stabilizing at a time when business outlooks are rising in tandem with consumer confidence. Continued improvement in global services and manufacturing Purchasing Managers’ Index (PMI) data adds support to this thesis. As 2017 progresses, we will be watching closely for a continuation of these trends.

We are hesitant to extrapolate the good news too far into 2017. The renewed strength in the dollar presents headwinds that are not specific to the United States but 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 may drive an increase in Chinese capital outflows during a time when China is walking the high wire, 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 hikes by the Fed in the upcoming year. As we close out 2016, the Fed’s “dots” forecast three moves in 2017 and appear to be exerting their gravitational pull on market expectations as well. Perhaps we usher in a new era of Fed hikes in the upcoming year, but as we mentioned last quarter, nothing can be taken for granted in a world burdened by debt and with subpar growth trends. The global search for yield should continue, but it may not be enough to support risk premiums for credit that are inside historical long-term averages. Avoiding idiosyncratic risks should provide the backdrop for our active, fundamental research-based approach to help navigate these challenging times.

The Bloomberg Barclays U.S. Corporate Investment Grade Index (formerly known as the Barclays U.S. Corporate Investment Grade Index) is composed of U.S. dollar–denominated, investment grade, SEC-registered corporate bonds issued by industrial, utility, and financial companies. All bonds in the index have at least one year to maturity.

The Purchasing Managers’ Index, published by Markit Group, is an indicator of the economic health of the manufacturing sector.

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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 (03/31/2017)
Current
quarter
YTD1 year3 year5 year10 yearLifetimeInception
date
Class A (NAV)1.87%1.87%3.67%4.23%5.89%8.31%7.93%09/15/1998
Class A (at offer)-2.78%-2.78%-1.02%2.64%4.91%7.81%7.66%
Institutional Class shares1.93%1.93%3.93%4.49%6.16%8.57%8.20%09/15/1998
Bloomberg Barclays Long U.S. Corporate Index1.36%1.36%5.29%5.36%5.60%6.98%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 Long U.S. Corporate 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)1.00%
Class A (Net)0.96%
Institutional Class shares (Gross)0.75%
Institutional Class shares (Net)0.71%

Net expense ratio reflects a contractual waiver of certain fees and/or expense reimbursement from Nov. 28, 2016 through Nov. 28, 2017. Please see the fee table in the Fund's prospectus for more information.

Share class ticker symbols
Institutional ClassDEEIX
Class ADEEAX
Class CDEECX
Class RDEERX
Class R6DEZRX

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 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.

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