As of 03-31-2017

Market Overview

The so-called “Trump rally’’ led equity markets to all-time highs in the first quarter of 2017, as investors hoped that the combination of Donald Trump’s election as president and a Republican Congress would lead to the implementation of a pro-growth agenda. The optimism waned as the quarter progressed, however, although equity markets easily finished in positive territory. The Federal Reserve also made headlines, announcing in March its second rate hike in three months.

Domestic equity market optimism centered on hopes that a GOP White House and Congress would follow through on some of candidate Trump’s initiatives, including corporate tax reform, regulatory rollbacks and an increase in infrastructure spending. But after the major indexes hit new highs in early March, those hopes diminished somewhat when legislation to repeal and replace Obamacare didn’t even have enough support for a House vote, causing a mild pullback that left the major indexes just shy of their record highs by quarter-end.

Another driver for domestic stocks throughout the quarter was improving macroeconomic data. Strong results in employment, housing, spending, manufacturing and consumer sentiment not only led equity prices higher, but were an impetus for the Fed’s decision to raise the target funds rate by another 25 basis points in mid-March, following last December’s identical hike. As they did in December, equity investors shrugged off the widely expected announcement, interpreting it as a sign of economic growth.

The “Trump rally” was not limited to the U.S. during the period as both developed and emerging market (EM) equities also flourished during the first three months of 2017. Brexit drove a lot of the headlines as the U.K. formally triggered Article 50 starting the clock on leaving the European Union. Additionally, OPEC was in the news as crude oil prices declined in the quarter, leaving the market to wonder if the OPEC production cut struck late in 2016 was enough in light of U.S. shale ramping up production.

The second quarter of 2017 could be volatile as we expect headlines out of Washington to continue to drive the market. The market would like to see progress on the Trump agenda – mainly tax reform and infrastructure. With the apparent setback in health care, tax reform becomes a priority. A risk to tax reform is that the health-care debate rears its head again, pushing back the timeline on tax reform. Positive movement on tax reform could be a catalyst for a market move higher, while delays and uncertainty could cause a decline. The debate around the border-adjustment tax (BAT) also is worth watching as this could not only determine the success or failure of tax reform, but also drive sector winners and losers.

The Fed has the potential to move the markets, as well. Expectations are for an additional two or three hikes this year, but the bigger debate is turning to the balance sheet and reducing its holding of Treasury and mortgage-backed securities (MBS). Could this turn into another taper tantrum a la 2013? Although we expect some progress on the Trump agenda, at this point, given relative market valuations – which are no longer cheap – we believe a balanced portfolio of cyclical and defensive companies that have strong cash flow, balance sheets and improving fundamentals will help navigate the undulating waters that we are experiencing.

During the quarter, U.S. Treasury rates increased the most in the front of the yield curve, while longer rates declined slightly. Specifically, interest rates for maturities from one month to a year increased by 20 to 30 basis points, compared to a 5 basis-point decline for the 10- and 30-year maturities. As a result, the U.S. Treasury curve flattened. This is a typical market reaction for the yield curve following a fed funds rate increase. However, after mid-March increase, the market interpreted Chairwoman Janet Yellen’s subsequent press conference comments to be more dovish than expected, which put downward pressure on longer-term rates.

Despite a weaker end to the quarter, all fixed-income asset classes reported positive total returns for the period, with the lower quality credit sectors reporting the largest total returns. The total return for the Bloomberg Barclays US Treasury Index was 0.67%, compared to 3.28% for the Bloomberg Barclays Emerging Markets Index. In addition, all of the major fixed-income markets, except agency mortgages, outperformed the U.S. Treasury market on a duration-adjusted basis.

For the first quarter of 2017, the Bloomberg Barclays Aggregate Index returned 0.82%, the Bloomberg Barclays Treasury Index returned 0.67%, the Bloomberg Barclays Mortgage Index returned 0.47%, the Bloomberg Barclays Commercial Mortgage Index returned 0.86%, the Bloomberg Barclays Investment Grade Corporate Index returned 1.22%, the Bloomberg Barclays High Yield 2% Issuer Capped Index returned 2.70%, and the Bloomberg Barclays Emerging Markets USD Aggregate Index returned 3.28%. In addition, the S&P 500 Index returned 6.07% and the Russell 1000 Value Index return 3.27%.

Fund Performance

The fund met its primary goal of current income and long-term growth of income during the quarter. The fund’s 12-month yield for A Shares at net asset value (NAV) was 3.95% at quarter-end, with a 30-day SEC yield of 2.92%. The fund’s yield was well above the S&P 500 dividend yield at 1.91%; Russell 1000 Value Index at 2.34%; 10 year Treasury yield at 2.39% and Morningstar Conservative Allocation average at approximately 2.22%. The fund received 15 dividend increases during the first quarter including Valero, Allstate, and Qualcomm.

For the first quarter, Federated Capital Income Fund A Shares returned 2.72% at NAV, outperforming the 2.60% return of the fund’s benchmark comprising of 40% Russell 1000 Value Index, 20% BBHY2%ICI, 20% BBMB, and 20% BBEMB Index.

Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than what is stated. Other share classes may have experienced different returns than the share class presented. To view performance current to the most recent month-end and for after-tax returns, click on Performance tab. Performance does not reflect the maximum 5.5% sales charge for Class A Shares. If included, it would reduce the performance quoted.

Click the Performance tab for standard fund performance.

During the quarter, within the equity markets, growth stocks outperformed value stocks. For the quarter, the Russell 1000 Growth Index returned 8.91% while the Russell 1000 Value Index returned 3.27%. In terms of asset allocation, the Russell 1000 Value Index outperformed both the broader Bloomberg Barclays Aggregate Index and the Bloomberg Barclays Treasury Index. The fund is overweight equities at 46% of its asset allocation relative to its neutral 40% equity index exposure. The equity relative overweight, which has helped performance since 2010, was a positive contributor during the quarter.

In the equity portfolio, both stock selection and sector weight added to the fund’s overall performance. Relative to the fund’s Russell 1000 Value Index benchmark, the three best-performing sectors were Information Technology, Industrials and Consumer Discretionary. The three sectors that most negatively contributed to fund performance were Utilities, Financials and Telecom Services.

On an absolute basis the five securities contributing most fund performance were Apple, Alibaba (Conv. Pfd.), HP, Applied Materials and Allergan (Conv. Pfd.). The five positions detracting most from performance were Nabors Industries, Verizon, Baker Hughes, Helmerich & Payne and Franks International.

Click on the Portfolio Characteristics tab for the fund’s top ten holdings.

The fixed-income portfolio return of 2.35% outperformed its blended benchmark by 29 basis points during the second quarter, and materially outperformed the higher quality Bloomberg Barclays U.S. Treasury and Bloomberg Barclays U.S. Aggregate indices by 168 and 153 basis points, respectively. Security selection was the largest positive contributor to performance, due primarily to positive security selection in the MBS and EM portions of the portfolio. Sector allocation was a positive contributor to performance due to the overweight to high yield and an underweight to MBS. Duration was the small negative contributor to performance due to being on average 90% of fixed income blended benchmark’s duration.

Positioning and Strategy

The fund continues to strive to achieve its primary goal of current income and long-term growth of income with capital appreciation as a secondary objective.

We remain broadly diversified within equity market sectors, with a prudent approach to balancing income, risk, and long-term total return. The fund’s equity holdings are positioned within a diversified portfolio of income-producing securities and dividend-growing stocks with favorable valuations, strong balance sheets and improving business fundamentals. The portfolio continues to aim for high yield and consistent dividend growth.

Sector overweight positions relative to the fund’s Russell 1000 Value Index benchmark include Information Technology, Consumer Discretionary and Health Care. The fund’s largest underweight positions include Financials, Utilities and Energy.

The fixed-income portfolio remains slightly overweight high yield, neutral in the EM sector and slightly underweight the higher quality corporate and mortgage markets relative to the fixed-income portfolio’s blended benchmark. The portfolio had an average effective duration of 3.89 years vs. the benchmark at 4.31 years. The fixed-income portfolio is positioned neutral relative to the yield curve.