An Update from the Delaware Investments Fixed Income team: Comments on the bank loan market

Bank loans — syndicated loans to large and midsize below-investment-grade corporations — were long considered an outlying, alternative asset class. With institutional investors increasingly deploying them in diversified portfolios and other investment strategies, bank loans have matured into an important piece of a diversified fixed income strategy.

Bank loans were caught in the middle of a tsunami of historically poor technical conditions during the recent credit crisis; however, prices have recovered to the point at which we believe they are more fully valued once again. Despite the recent volatility, we continue to believe that bank loans play a valuable part in a diversified fixed income portfolio.

Today’s bank loan market

The leveraged loan market has experienced steep growth since the early to mid-1990s, as corporate borrowing, as well as merger and acquisition activity, markedly increased during that time frame. It is our belief that the large ramp-up in issuance could lead to tighter underwriting standards in the future.

Today’s loan market is a diverse one. No one industry dominates the marketplace at current trading levels.

Par amount of outstanding bank loans (in billions)

Source: Standard & Poor's

Why bank loans?

• We believe they offer the potential for equity-like returns in certain instances, without the use of leverage.
• Interest rates tend not to be a key driver of price performance given their floating rate structure.
• They are viewed by many as defensive investments, especially when prevailing interest rates are expected to climb, or when the yield curve is expected to flatten.
• Bank loans feature historically high recovery rates relative to other fixed income asset classes.

Recovery rate at various levels of the capital structure - (1987 - 2008)

Source: Moody's Inc. Data based on analysis of more than 4,000 loans and bonds that defaulted between 1987 and 2008.

• Bank loans have senior status in the capital structure. The prospect of rising corporate defaults in 2009 and 2010, together with the potential for increased inflationary pressures in the years ahead, points to a good argument for investing in a senior place in the capital structure.
• Diversification: Although correlations to riskier asset classes have increased, we believe that loans remain complementary to other asset classes.

Bank loans versus high yield bonds

Our bank loans strategy

Within our institutional fixed income strategies, we’ve seen interest in bank loans as an asset class that may improve risk-adjusted returns through multiple market cycles. Accordingly, we expect bank loans to remain part of our multisector fixed income portfolios, ranging between 1% and 5% of each portfolio. Our investment strategy is multifaceted:

• We target asset-rich companies. Every loan we invest in has to meet our rigorous credit standards. As part of our bottom-up analysis, we scrutinize each issuer’s capital structure, study maintenance covenants, and determine each issuer’s ability to compete effectively. Our investment decisions are informed by the collective expertise of portfolio managers, research analysts, and loan traders; together, the efforts result in a comprehensive review of the fundamentals that drive each loan issuer’s performance.
• First and foremost, we’re focused on identifying quality loans. Our philosphy involves not chasing yield at the expense of quality.
• Every loan in which we invest has a specific objective. The core of our holdings consists of loans to companies with relatively stable fundamentals and technicals (expressed as low beta).
• Additionally, however, we target specific credits whose rating we anticipate may be upgraded, or loans that we believe are undervalued. We also tend to invest in what we believe are opportunistic trades, including those which we believe may be refinanced, or pricing dislocations within an issuer’s capital structure.
• Our portfolio positioning tends to emphasize loans that are:
  
  • high in the capital structure
  • underwritten by asset-rich companies
  • of a higher quality and are covenant-rich

Important information

Delaware Investments is the marketing name for Delaware Management Holdings, Inc. (DMHI) and its subsidiaries. DMHI is a Lincoln Financial Group^® company. Lincoln Financial Group is the marketing name for Lincoln National Corporation and its affiliates. Delaware Investments^® funds are distributed by Delaware Distributors, L.P., an affiliate of Delaware Management Business Trust (DMBT), DMHI, and Lincoln National Corporation.

Investing involves risk, including the possible loss of principal.

Diversification may not protect against market risk.

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. Fixed income securities may also be subject to prepayment risk, the risk that the principal of a fixed income security may be paid prior to maturity, potentially forcing a strategy 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.

Investments in derivatives may involve additional expenses and are subject to risk, including the risk that a security or securities index to which the derivative is associated moves in the opposite direction from what the portfolio manager anticipated. Another risk of derivative transactions is the creditworthiness of the counterparty because the transactions rely upon the counterparties’ ability to fulfill their contractual obligations.

The views expressed represent the Manager's assessment of the strategy and market environment as of June 1, 2009, 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.