As of 09-30-2017

Market Overview

In the third quarter of 2017, U.S. equity markets reached all-time highs in the face of geopolitical uncertainty, severe natural disasters, continuing noise out of Washington, D.C., and the Federal Reserve’s unveiling of plans to normalize its balance sheet.

On the domestic front, stories out of Washington dominated the headlines. Failed efforts to repeal and replace the Affordable Care Act and a government shutdown that nearly came to fruition were among the primary domestic issues that investors looked past as equity markets continued to advance. Equity markets also shook off Hurricanes Harvey and Irma, some of the most devastating storms in more than a decade, as the S&P 500 finished higher for the eighth consecutive quarter while volatility continued to remain quite low. Despite all of the distractions, investors remained focused on the increasing potential for corporate tax cuts, which would provide a boost to the economy and potentially build on the strong year-to-date corporate earnings.

Looking abroad, geopolitical tensions between the U.S. and North Korea represented the main source of news throughout the quarter, creating a few short-lived episodes of weakness in equity markets that served as buying opportunities. Stronger economic data in Europe and Japan were additional tailwinds for equity investors throughout the three-month period, aided by a U.S. dollar that began to reverse its 2017 slide.

The fourth quarter of 2017 begins optimistically with a renewed hope that one of the main pillars of President Trump’s agenda—and arguably the most important for investors, tax reform—will move through Congress. The initial proposal of a 20% corporate tax rate and move to a territorial tax system would be bullish for equities. No doubt there will be tough negotiations ahead in Washington, creating volatility in the markets, but we believe a tax package ultimately will pass, helping propel stocks higher. A key item to watch will be whether Congress can pass a 2018 budget resolution.

Moving to the Fed, the balance sheet unwind is set to begin in October with a monthly $10 billion reduction ($6 billion in Treasuries and $4 billion in mortgage-backed securities, or MBS) that will increase quarterly until it reaches a $50 billion-per-month threshold. This plan had been well telegraphed by the Fed and we do not expect it to create any major market disruptions. We also continue to expect one more rate hike in December. With the economy continuing to grow steadily, we expect another solid earning season and, coupled with strong seasonality, a continued march higher in equity prices. 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-sheet strength and improving fundamentals will help navigate the current investment landscape.

In fixed income, U.S. Treasury rates declined through the first two months of the quarter due to the aforementioned geopolitical risks and hurricane damage. Uncertainty over the resolution of the U.S. debt ceiling and the seasonally slow summer months also were a drag. However, after investor attention re-emerged following Labor Day and the previously mentioned headline risks faded somewhat, U.S. Treasury rates mostly rose in September and were up for all maturities across the curve for the quarter. The U.S. Treasury curve flattened slightly in the quarter, consistent with investors’ expectations that the Fed will continue to gradually raise its target funds rate. The latest Federal Open Market Committee (FOMC) projections forecast another hike this year and three more in 2018. However, slow but stable U.S. economic growth and weak inflation data continue to put downward pressure on longer-term rates, even as previously noted, the Fed is starting to shrink its balance sheet.

All major U.S. fixed income asset classes reported positive total returns for the third quarter with all of the credit sectors outperforming the Bloomberg Barclays U.S. Treasury index. For the quarter, the Bloomberg Barclays U.S. Treasury Index returned 0.38%, the Bloomberg Barclays Aggregate Index returned 0.85%, the Bloomberg Barclays Mortgage Index returned 0.96%, the Bloomberg Barclays Commercial Mortgage Index returned 0.79%, the Bloomberg Barclays Investment Grade Corporate Index returned 1.34% and the Bloomberg Barclays Emerging Markets USD Aggregate Index returned 2.27%. In addition, the S&P 500 Index returned 4.48% and the Russell 1000 Value Index returned 3.11%.

Fund Performance

The fund met its primary goal of current income and long-term growth of income during the third quarter of 2017. The fund’s 12-month yield for A Shares at net asset value (NAV) was a net 3.93% at the end of the quarter, with a 30-day SEC yield of 2.85%. The fund’s yield was well above the S&P 500 dividend yield at 1.85%; Russell 1000 Value Index at 2.31%; 10-year Treasury yield at 2.33% and Morningstar U.S. Allocation 30%-50% Equity average at approximately 2.22%. The fund received about 10 dividend increases during the third quarter including Comerica, Verizon and McDonalds.

For the third quarter, Federated Capital Income Fund A Shares returned 3.11% at NAV, outperforming the 2.30% 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.

Within the equity markets, growth stocks outperformed value stocks during the quarter, with the Russell 1000 Growth Index returning 5.90% and the Russell 1000 Value Index returning 3.11%. In terms of asset allocation, the Russell 1000 Value Index outperformed the broader Bloomberg Barclays Aggregate Index as well as the Bloomberg Barclays Treasury Index. The fund is overweight equities at 47% 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, stock selection and sector weight both 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 Materials. The three sectors that most negatively contributed to fund performance were Health Care, Financials and Consumer Staples.

On an absolute basis the five securities contributing most fund performance were Lam Research, Texas Instruments, Applied Materials, Harris Corp. and PBF Energy. The five positions detracting most from performance were Allergan PLC Conv. Pfd., Quest Diagnostics, J.M. Smucker, Teva Pharmaceutical and Delta Air Lines.

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

The fixed-income portfolio outperformed its blended benchmark and also outperformed the higher-quality Bloomberg Barclays U.S. Treasury and Bloomberg Barclays U.S. Aggregate indexes. Security selection was the largest positive contributor to performance, due primarily to positive security selection in the emerging-market and high-yield portions of the portfolio. Sector allocation also was a slight positive contributor due to the overweight to high yield and an underweight to MBS. The impact of interest rates on the portfolio was immaterial in the quarter. The fund’s duration position was less than the fixed-income portfolio’s benchmark of 4.53 years during the quarter.

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, Industrials and Materials. The fund’s largest underweight positions include Financials, Energy and Consumer Staples.

The fixed-income portfolio remains slightly overweight high yield, neutral in the emerging-market sector and slightly underweight the investment-grade corporate and mortgage markets relative to the fixed-income portfolio’s blended benchmark. The fixed-income portfolio’s duration remains less than the duration of the benchmark, and the portfolio is positioned neutral relative to the yield curve.