Perspectives

Weathering interest rate changes

In the world of fixed income, investors often speculate about the future direction of interest rates. Changes in either direction can affect the value of a fixed income portfolio. But clarity about interest rate trends does not come easy.

Even when economists and other financial experts agree on economic trends, there is often conflicting opinion about the future direction of interest rates. This is due in part to the fact that various factors can influence the interest rate outlook in an economy as broad and complex as that of the United States. Economic indicators may conflict, and signs of health in one sector of the economy may be accompanied by signs of weakness in others.

Depending on how your investment portfolio is structured, interest rate movements may not require an overhaul of your asset mix. At Delaware Investments, we remind investors that fixed income assets play a key role in building a well-diversified asset allocation that seeks to weather change. Fixed income investments can add stability to a portfolio, acting as a counterweight to stocks and helping to temper portfolio-level risk. With a well-planned fixed income strategy, it is possible to reap the benefits of diversification in any environment. Diversification does not, however, assure a profit or protect against loss in a declining market.

When it comes to managing interest rate fluctuations, investors should keep in mind that interest rates are seldom extraordinarily volatile. Swings in interest rates are usually progressive and relatively orderly. History has shown that extraordinary fluctuations don't last forever, and relatively long stretches of stable rates are not uncommon.

Your financial advisor can help you navigate the fixed income market with greater confidence whenever interest rates do change. We encourage you to speak with your advisor before making any changes to your investment portfolio.

Fluctuating interest rates: issues for fixed income investors

Generally, periods of falling interest rates are beneficial to fixed income investors, while periods of rising interest rates are relatively challenging, due largely in part to this relationship:

When interest rates fall, prices of existing bonds usually rise.

When interest rates rise, prices of existing bonds typically decline.

In general, the following can help minimize the risks associated with changing interest rates:

Build a fixed income allocation that includes various types of fixed income assets.
Consider your risk tolerance and income needs when selecting your fixed income investments.

While an "all-weather" fixed income allocation may be a worthy goal, specific strategies exist that may be suitable in specific environments. Let's consider those that may work well during periods of shifting interest rates. We'll address falling rates first, then an environment in which rates are rising.

Strategies that investors might consider when interest rates are falling

A shift toward longer-term bond funds

Falling interest rates often mean rising prices for existing bonds, especially for bonds with longer maturities, which are more sensitive to changes in interest rates than short-term bonds. Short-term bonds will reach maturity sooner, and these bonds have less time to be affected by interest rate swings.

If rates are declining partly as a result of weakening corporate profits, it can be important to monitor the quality of your corporate bond investments. Talk to your financial advisor about these considerations in light of your financial plan and the current environment.

Consider rebalancing via fund exchanges

If you and your advisor decide to rebalance your portfolio, transactions need not be complex or expensive. At Delaware Investments, you can exchange all or part of your shares in any Delaware Investments mutual fund for shares of the same class in another Delaware Investments fund without paying a front-end sales charge or a contingent deferred sales charge at the time of the exchange.*

When you exchange shares, you are purchasing shares in another fund, so be sure to get a copy of the new fund's prospectus and read it carefully before making the exchange.

*If you exchange shares from a money market fund that does not have a sales charge, you will pay any applicable sales charges on your new shares. When exchanging Class B and Class C shares of one fund for the same class of shares in other funds, your new shares will be subject to the same contingent deferred sales charge as the shares you originally purchased. The holding period for the contingent deferred sales charge will also remain the same, with the amount of time you held your original shares being credited toward the holding period of your new shares. You don't pay sales charges on shares that you acquired through the reinvestment of dividends. Exchanging shares is considered a taxable event to the IRS, and you may have to pay taxes on your exchange. When you exchange shares, you are purchasing shares in another fund so you should be sure to get a copy of the fund's prospectus and read it carefully before buying shares through an exchange.

Consider other income-producing assets

Mutual funds that invest in foreign fixed income markets. These funds provide access to fixed income markets that do not always move in direct correlation with domestic markets. By spreading risk among issuers in different parts of the world, this type of mutual fund may help certain investors achieve their desired balance between risk and reward. Delaware Diversified Income Fund is an example of a fund that fits this category. The fund's managers can invest up to 50% of its assets in bonds issued by companies and governments in countries outside of the U.S. Of course, foreign investments are subject to risks not ordinarily associated with domestic investments, such as currency risk, economic risk, political risk, and differing accounting standards.

Dividend-oriented equity funds. Combining fixed income investments and equity income may be an appropriate strategy for investors who aim to stay ahead of inflation and seek to make their nest eggs last. These funds buy stocks in companies that have histories of making consistent dividend payments. (Keep in mind though that no dividend payments are guaranteed to continue in the future.) Delaware Dividend Income Fund, for example, holds securities from several major income-producing asset classes, including dividend-paying equities, bonds, and REITs.

REITs, or real estate investment trusts, are publicly traded companies that usually manage real estate portfolios and traditionally offer dividends. Funds that invest in REITs are subject to many of the risks associated with direct real estate ownership, and as such may be adversely affected by declines in real estate values and general and local economic conditions.

Strategies that investors might consider during periods of rising interest rates

Whether interest rates are rising or falling, generally speaking, investors seek to position their portfolios to take advantage of asset classes that tend to fare well in the prevailing interest rate landscape and that are suited to their investment goals.

When interest rates are rising, there are several strategies to consider.

A shift toward corporate bond funds

In times of economic strength, the outlook may be brighter for corporate debt securities than for U.S. Treasury bonds. Corporate bond prices, which are linked in part to the strength of corporate earnings, may hold up better than Treasurys in a rising interest rate environment.

Reinvesting bond income in higher-yielding instruments

While higher interest rates may drive down the prices of bonds held by many mutual funds, the interest payments on those bonds should continue to be made in the same dollar amount. Keep in mind that a bond's interest payment — which is calculated as a percentage of the bond's original face value — remains unchanged despite variations in interest rates. Particularly active investors might consider reinvesting those interest payments at the new, higher rates that are prevailing in the market. To do this, they may reinvest distributions from fixed income funds into funds that may benefit explicitly from climbing rates, such as money market funds and inflation-protected funds.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of an investment at $1.00 per share, it is possible to lose money by investing in a money market fund.

Inflation-protected debt securities tend to react to changes in interest rates, that is, the expected impact of inflation on interest rates. In general, the price of an inflation-protected debt security can fall when interest rates rise, and can rise when interest rates fall. Interest payments on inflation-protected debt securities will vary as the principal and/or interest rate is adjusted for inflation.

Holding more than one fund

Another way to spread risk across the bond markets is to hold several mutual funds that focus on different sectors. Such a portfolio might include funds that specialize in bonds issued by a range of different entities, including the following:

Corporations
Agencies of the U.S. government
U.S. municipalities
Foreign governments
Foreign corporations

Your financial advisor can help you identify those opportunities that align with your tolerance for risk. Make your primary objectives clear to your advisor, so that your advisor can help tailor a plan to fit your needs.

Consider diversifying

While no investment mix can provide complete immunization against interest rate fluctuations, investors who focus on diversification by spreading out investments across different asset classes may have a good chance of staying on track in meeting their investment objectives. Of course, diversification doesn't assure a profit or protect against loss in a declining market, and there can be no assurance that a diversified portfolio will outperform a non-diversified one.

Notes

Important disclosure information about Delaware Diversified Income Fund

A rise/fall in interest rates can have a significant impact on bond prices and the net asset value of the fund. Funds that invest in bonds, particularly those with longer maturities, can lose value as interest rates rise and an investor can lose principal.

Foreign investments are subject to risks not ordinarily associated with domestic investments such as currency, economic and political risks, and different accounting standards.

Investing in emerging markets can be riskier than investing in well-established foreign markets.

Effective May 24, 2007, portfolio management responsibilities for the Fund changed. Please see the Fund's current prospectus, as supplemented, which contains important information regarding the investment manager for the Fund.

Effective Aug. 24, 2007, Kevin Loome, who is head of high yield investments, was added as a portfolio manager to the Fund. Please see the prospectus, as supplemented, for more information.

Investors should consider the investment objectives, risks, charges, and expenses of the investment company carefully before investing. The prospectus contains this and other important information about the investment company. Please request a prospectus by calling 800 523-1918 or by visiting our Web site at www.delawareinvestments.com. Read it carefully before you invest or send money.

Important disclosure information about Delaware Dividend Income Fund

High-yielding, non-investment grade bonds (junk bonds) involve higher risk than investment grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities. The Fund may invest up to 45% of its assets in high yield, higher risk corporate bonds.

A rise/fall in interest rates can have a significant impact on bond prices and the net asset value of the fund.

Funds that invest in bonds, particularly those with longer maturities, can lose value as interest rates rise and an investor can lose principal.

Funds that invest a significant portion of their assets in one industry or region, or in related industries may involve greater risk than more diversified funds, including greater potential for volatility. Funds that invest in REITs are subject to many of the risks associated with direct real estate ownership, and as such may be adversely affected by declines in real estate values and general and local economic conditions.

The Fund may use futures and options for defensive strategy purposes to protect or neutralize the impact of interest-rate changes.

Foreign investments are subject to risks not ordinarily associated with domestic investments such as currency, economic and political risks, and different accounting standards.

Effective May 24, 2007, portfolio management responsibilities for the fixed income portion of the Fund changed. Please see the Fund's current prospectus, as supplemented, which contains important information regarding the investment manager for the Fund.

Effective Aug. 24, 2007, Kevin Loome, who is head of high yield investments, was added as a portfolio manager to the Fund. Please see the prospectus, as supplemented, for more information.