Q:  What is the makeup of the municipal investing team? A : We are a 13-member experienced team with an average experience of 20 years in the municipal bond industry. I am one of three portfolio managers and I report to Joe Baxter, the head of the municipal investing group since 2004. I joined Delaware in 2004, and since early 2007 I’ve been a portfolio manager on our National High Yield Municipal Bond Fund, as well as other muni strategies. In addition to three portfolio managers, we have three traders, one portfolio analyst, and six dedicated research analysts on our team to analyze municipal bonds and some taxable municipal bonds including Build America Bonds, which are taxable municipal bonds issued between February 2009 and the end of 2010. Q:  How are the responsibilities among team members divided? A : There are three portfolio managers, each with a special focus. For example, I’m the lead portfolio manager for our tax exempt high yield fund. That being said, when we talk about strategy and bonds that actually find their way into the portfolio, it’s really a team effort. The three portfolio managers map out each strategy delivered through an array of products including closed-end mutual funds, institutional accounts, and retail mutual funds. After we map out each strategy, the entire team works together to flesh it out and implement. For example, the traders and portfolio managers have responsibility for tracking the marketplace and assessing relative value. But the portfolio analyst also keeps an eye on the marketplace when looking at various credits or bonds, and gives us an understanding of each specific bond and where it is trading compared to similar bonds. We each provide valuable information, and at the end we do try to come to a consensus. But the lead portfolio manager has the final say about what goes in the portfolio and what comes out of the portfolio. Q:  How has the municipal market evolved and what are the nuances in that market? A : The municipal bond market is a regionalized and a fragmented market that requires hands-on experience and a detailed understanding of investments. We want to track the market and have an understanding of what’s happening to credit spreads, and movement of interest rates, as far as rates rising or rates falling, and what the supply-demand dynamic looks like. There are so many different nuances when it comes to municipal credit and there are almost 35,000 issuers in our marketplace. There are a lot of small deals that you see infrequently and there are also prolific issuers. I think the credit crisis of 2008 and 2009 produced some substantial changes in our marketplace. This happened in October-November of 2008 when Lehman Brothers collapsed, but the credit crisis was starting to evolve even before then. Prior to that event, 62% of all municipal issues, bonds that were outstanding, were wrapped with the insurance compared to 12% today. Q:  What kind of muni bonds do you look at? A : We were never big buyers of insurance, meaning insured bonds, and we preferred to look at a bond that was not insured. We didn’t really want to pay for the insurance instead we preferred to look at the underlying credit of each issue. Basically, our market has turned more into a credit market. When you had 62% of the securities on the market AAA-rated due to the mono-line wrap, there was more of a homogenous trading range of securities. That’s not the case today. Now, these securities are trading on their underlying merit. For us, that’s a good thing. It gives us a better opportunity to buy bonds with wider spreads and higher yield on a rollout basis than we could have had before the onset of the credit crisis. Moreover, Congress pursued the issuance of Build America Bonds. That attracted new buyers and a new awareness of municipal credit by insurance companies, hedge funds, and foreign investors, all of whom did not participate in our market prior to the credit crisis. One more impact of the credit crisis is that there’s not as much liquidity provided by securities dealers as there was prior to the crisis. Muni bonds have always been somewhat illiquid in the sense that there is liquidity until there isn’t, but that has actually been magnified with the consolidation of dealers throughout the crisis, and there is less capital committed by dealers. We always preferred to buy bonds that were not mono-line wrapped, and bought the underlying credit based on its own merits. And we were comfortable with the securities that we did purchase that way, whether they were an A-rated credit, BBB-rated credit, or below investment grade, due to our ability to analyze the risk within those securities. Paying for mono-line insurance is something that did not make a lot of sense for us at Delaware Investments. Q:  How does the muni bond investing team operate? A : We are members of a larger fixed income team, comprised of 85 professionals, here at Delaware Investments. We are on the trading desk with corporate high yield, corporate investment grade, emerging markets, and money markets teams. We participate in their meetings and they participate in our meetings, so there are a lot of cross-currents because of some overlap with certain securities. For example, U.S. Steel. We do have an analyst on our team who is responsible for covering U.S. Steel, so we also cover U.S. Steel on the taxable side. We have communication between our taxable analyst and our tax-exempt analyst on that one credit. It really is an area where you can bounce ideas off one another and get varied opinions about a single credit. Also, we have a variety of different portfolios in which municipals bonds are used even though they are taxable portfolios. We use municipals from a total return standpoint where, for example, we are an opportunistic sleeve, or in a portfolio where we might dedicate anywhere from 5% to 25% of the assets of that portfolio to municipals at any given time due to the relative value of those securities when looking for a total return opportunity across all fixed income groups. We have $5.7 billion in assets under management and the tax-exempt high yield fund currently has $714 million in assets. We manage 12 municipal mutual funds, three closed-end mutual funds, and institutional accounts. Q:  What drives your investment strategy and process? A : The most important thing for us is our bottom-up security selection process, which is driven by the fundamental credit research conducted by our six analysts. We focus on income, as we believe it’s the key to total return. Income is the most significant and predictable component of total return over time. Bond price varies so it’s less predictable. We have a straightforward strategy and it’s a two-pronged one. We strive to be in the top third of distribution yield relative to the average of the Lipper peer group. So, why only top-third and not top-decile? The reason is that the high-yield portion of the municipal market is very small. Below- investment-grade paper makes up only about 10% of the bonds issued. If you try to add too much income to your fund due to the lack of paper you start overweighting issuers. That’s not what we do. We believe in diversification; this is especially important in a high-yield fund due to the lower quality and the higher risk of the securities. We believe in a managed approach and we believe in income, but the income distribution is really important to us. So being in the top-third is the sweet spot from a distribution yield perspective. Secondly, we strive to be in the top-half of total return versus the average of our Lipper peer group year-in and year-out. We add excess return into the portfolio through our credit selection. We have a weekly meeting discussing the economics of the week and the prior week, and we discuss what’s going on globally. Our colleagues from the taxable side participate as well. We try to stay duration neutral relative to the average of the peer group and add excess return through our credit selection. When we put those two goals together -- top-third in distribution yield and top-half in total return -- we have found this approach has generally produced top quartile performance for our funds over the long term. . Q:  Please explain the below investment grade segment of the market? A : Before we buy a bond, we assign an internal rating based on our credit analysis of that security and we trade based on our internal rating, which may not correspond with the published ratings. What is most important to us is what our analysts think about a credit and the rating they have assigned to it. In the below-investment-grade segment of our market, the biggest portion is non-rated securities. For example, in our portfolio, 21% of its securities are non-rated. We find that average internal rating on those non-rated securities is BB. Q:  How is a high-yield municipal fund different from high-yield taxable bond fund? A : High-yield municipal funds in general don’t look very much like a high yield taxable fund from a quality distribution. In a typical high-yield taxable fund, 95% of the securities are below investment grade. However, in an average high-yield municipal fund, only about 50% of the securities are below investment grade, the rest are investment grade. This is because there is less paper issued that is below investment grade. If you built a high-yield municipal portfolio that’s 95% below investment grade, you would be overweight a variety of different names and giving an inordinate amount of risk to your shareholders. The largest quality tier in our tax-exempt fund is the BBB-rated –component which is about 30% of this portfolio. Right now we are running 44.5% below investment grade and the remaining 55% is in investment grade bonds. The average rating of a taxable high-yield fund is B, and the average rating of a tax-exempt high-yield mutual fund is BB. Ours is rated slightly higher. Q:  What are the key metrics you look at and analyze across various issuers? A : There are so many different types of issuers in our marketplace: non-profit hospital credit, higher education credit, charter schools, operators of highways, bridges, toll ways, and airports. There are a large variety of different issuers and they all have different dynamics and different things that our analysts look at to determine whether or not a particular credit makes sense. We divide the municipal world along sector lines and we have six analysts tracking these sectors. For example, we have two dedicated hospital analysts, and a good part of their time is digesting and analyzing hospital credits, continuing care retirement communities, and other issuers in that sector. Looking at our high-yield fund, 25% of it is in some sort of healthcare credit, whether it be hospitals or continuing care retirement communities. Some are investment grade, and some are below investment grade. Most of the continuing care retirement communities are below investment grade or non-rated. We look at several factors when researching a credit, and using the example of healthcare, factors we look at include the economics of the service area, the customer base, the facility’s market share, management and governance, and patient volume, just to name a few. The ongoing surveillance of the credit is just as important as the initial research. We look at the facility’s balance sheet – the cash on hand. We look for signs of declining profitability. Do they have financial wherewithal to withstand potential declining revenues? We also look at the debt profile, how much debt is long- and short-term, and how much is fixed or variable interest-rate linked. We check if the credit has interest rate swap exposure – that’s important because if they have it upside-down on the interest rate swap they may have to post collateral. Do they have the money to post that collateral? Also, what are the pension obligations and how well are these obligations are funded? Also, do they have a debt service reserve fund? Typically these issuers will have a debt service reserve fund set aside to meet maximum annual debt service, so that gives them a little time if their cash is running low and their profitability is not what they think it should be. If they do need to draw on some reserves, the reserve pool of cash is there to maybe get them through the tough times to get them back on track. Q:  Do you have exposure to charter school bonds? A : About 7.5% of the high-yield portfolio is in charter schools. We have 31 charter schools in 14 different states, and the way we look at charter schools is similar to the way we view a hospital credit. We review the school’s demand profile and several other factors. For example, how friendly is the state relative to charter schools and the schools’ existence within that state? Most states pay per-student to the charter school, the funding doesn’t come from the local school district. Some states are friendlier than others. Q:  What is the breakdown between healthcare and education sectors in the fund? A : Healthcare makes up 25% of our fund and education is the second largest sector with nearly 19% in the fund, including the 7.5% of charter schools. The rest of it is made up of higher education, including student housing. Q:  Please explain your credit selection and analysis process. A : Municipal finance exists for the common good, and we like to look at credit selection from a “need” standpoint. For example, we participated in a very large deal in December 2012. It was about $781 million to build a desalination plant in Southern California, to provide water through the San Diego County Water Authority. We haven’t seen a desalination plant built in this country since 2003. , Here, you see municipal finance at work providing water for San Diego County residents. The type of financing used in this deal is called a Public Private Partnership, or a “P3.” The overall cost of this project was about $950 million. Of that, about $172 million was provided by a private equity investor and it, along with San Diego County Water Authority, will run the facility and provide the water. It is the private money, along with the public money -- or the bond market used to build this facility -- that helps to alleviate some of the drought in Southern California. This particular facility will be up and running around November 2015 and will provide 7% of the daily water usage for the San Diego County residents. Other examples of P3s we’re invested in include toll roads and rail lines. We are invested in one particular live rail line in Colorado that will connect Denver city to the airport. There are a variety of ways we’re seeing these P3s at work for the good of the public. Q:  What is your portfolio construction process? A : Our goal is to deliver high levels of tax-exempt income with the least amount of risk. . Portfolio construction starts at the individual security level. When deals are proposed in the marketplace, our three traders keep track of when those deals will be priced, who is pricing them, what type of structure they are talking about, and potentially what kind of price they are talking about. Our traders relay all the pertinent information back to our analysts, making sure that the analysts have all the appropriate documentation and reports they need to do a full analysis. We then assign an internal rating and look at pricing, as far as what we’re being paid for the credit risk that we’re taking. After reviewing the credit analysis report put together by the analyst, we discuss the issue and determine if the credit can find its way in the portfolio. We do pass on a lot of credits. We pass on half the deals that come into our marketplace, because our credit standards here are high. A lot of what goes into the portfolio is predicated on the fund flows and cash available. If we find that the credit has merit and that we are being paid for the credit risk we are taking, that bond will make its way into the portfolio. For this particular portfolio, we buy about 80% of what goes into it in the new issue market as opposed to the secondary market. The job of the traders is obviously to track the market and to see if there are other securities we may have passed on. We may have passed on a bond several years ago and that bond is now available in the marketplace, so we’ll have the analyst do another review We have bought bonds in the secondary market on a deal that we passed on initially due to the fact that the bond, the conditions of that facility, or of the issuing body had improved. Q:  When do you decide to sell? A : Our sell discipline is based on relative value. We might be able to improve the portfolio from a structure standpoint or overall distribution yield standpoint by selling one security, and buying a new issue. Most importantly, our sell discipline comes down to continuous surveillance. We might buy a bond that we believe has merit, but maybe after a year or two it just really isn’t working out. So the analyst will bring it to the team’s attention, and say we’ve given this facility or this issuer several quarters to see if they can work out their problems, and they just don’t seem to be able to turn it around. If the analyst issues a sell to me, that credit is sold. If a credit keeps tracking positively, there is no reason to sell. We will continue to hold on to that credit and we may hold it to maturity, as long as it continues to work out the way we believed it would when we initially bought it. We do not have any absolute targets as far as minimum or maximum from a pricing standpoint. Q:  What thinking goes into diversification and how do you do it? A : We like to keep the position size down to about a 0.5% to 1% of any given issuer or name. Since we are dealing with higher risk securities, we feel the diversification as a whole is important. In general, we believe mutual fund buyers, regardless of the type of fund they are buying, are buying for diversification reasons. Why buy a high-yield tax exempt fund? It’s for the assets of credit. If investors try to go out on their own and replicate a list of credits they just wouldn’t get the diversification that we have. They also likely wouldn’t have the credit expertise to deal with initial due diligence and the ongoing surveillance. Q:  How do you define risk and how do you manage it? A : Risk is the measure of the probability that we are going to be paid: our coupons as they come due and our principal as it comes due on a timely basis. The higher the likelihood, the lower the risk. The less likelihood, obviously the higher the risk. Out risk management is embedded in our philosophy we strive to be among the top third of our peers on a distribution yield basis. Of course, each bond we hold determines our risk level and we make sure we don’t look for the highest-yielding security for yield sake. Instead we manage our yield distribution in such a fashion that we are paid for the risks we’re taking. We take a long-term approach to how we distribute income relative to the risk we are taking in the portfolio. We view it as a marathon, not a sprint. In addition to the credit risk, we are not immune to interest rate risk and the risk that the tax exemption will be eliminated. We are always cognizant of these risks.