As of 03-31-2018

Market Overview

Volatility returned to the markets in the first quarter of 2018 as the S&P 500 finished in negative territory for the first time in 10 quarters. Drivers for equity underperformance during the quarter include heightened fears about inflation, threat of an impending trade war and Technology sector volatility.

Inflation fears sparked the initial market sell-off in late January and early February, fueled by accelerating wages and exacerbated by high-volume, algorithm-based trading that worsened volatility. Inflation and interest-rate worries were fed further in March, when citing a healthy economy, the Federal Reserve (Fed) under new Chair Jerome Powell again raised the federal funds target rate and signaled at least two more 25 basis-point hikes are likely this year. Layered over all this was increasing talk of tariffs and potential trade wars with Europe, China and the U.S.’s Nafta partners Canada and Mexico. While those fears eased in regards to Nafta and Europe, both U.S. and international equity markets struggled toward the end of March as trade tensions ratcheted up with China. In the Information Technology sector, news of widespread data sharing of Facebook users’ information sent waves throughout the highflying sector, adding to overall volatility. Despite higher volatility and the equity sell-off, economic data for the most part was relatively strong, with nonfarm payroll growth, consumer confidence and the final reading on fourth quarter GDP surpassing expectations.

As the calendar turns to the second quarter of 2018, we expect heightened volatility to stick around. Trade and tariff rhetoric is likely to continue in fits and starts, with a possible conclusion to the Nafta renegotiation on the horizon and a wide swath of possibilities on U.S.-China trade relations. Additionally on the international stage, a potentially high-stakes meeting between the U.S. and North Korea is tentatively scheduled for later in the second quarter. There no doubt will be headlines out of that meeting if it in fact happens. On the domestic political front, midterm elections are moving closer and we expect that to begin to make headlines near the end of the quarter. We view all these geopolitical events as both sources of volatility as well as opportunities as we get back to the fundamentals. We expect another strong earnings season as companies report first quarter 2018 results and tax reform begins to work its way into the real economy. In the medium term, we anticipate companies to step up capital expenditures as they take advantage of full deprecation provisions of the new tax law, creating potentially positive second and third order effects that will show up over the coming quarters. Given relative market valuations, which are cheaper now after the correction following a strong January, 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.

During the first quarter, U.S. Treasury rates increased for all maturities across the yield curve. However, different factors contributed to the increases at different points along the curve. For maturities of three years or less, the increase in interest rates continues to be driven by the Fed’s monetary policy decisions and gradual rate-hike path. Increases in rates at the longer end of the yield curve, maturities of five years and longer, are being driven by expectations for higher inflation, led in the first quarter by above-consensus average hourly earnings in the February jobs report. The 10-year Treasury yield peaked at 2.95% at the end of February, before closing the quarter at 2.80%. In addition, the federal budget that was passed in the quarter raised projected federal deficit forecasts, contributing to the upward pressure on longer-term rates.

For the first quarter of 2018, the Bloomberg Barclays Aggregate Index returned -1.46%, the Bloomberg Barclays Mortgage Index returned -1.19%, the Bloomberg Barclays HY 2% Issuer Cap Index returned -0.86%, and the Bloomberg Barclays Emerging Markets (EM) USD Aggregate Index returned -1.48%.  In addition, the S&P 500 Index returned -0.76% and the Russell 1000 Value Index return -2.83%.

Fund Performance

The fund met its primary goal of current income and long-term growth of income during the first quarter of 2018. The fund’s 12-month yield for A Shares at net asset value (NAV) was 4.09% at the end of the quarter, with an SEC yield of 3.03%. Its yield was well above the S&P 500 dividend yield at 1.84%; Russell 1000 Value Index at 2.39%; 10 year Treasury yield at 2.74%; and Morningstar Conservative Allocation average at approximately 2.47%. The fund received five dividend increases during the first quarter, including Aflac, Gilead Sciences and Altria Group.

For the first quarter, Federated Capital Income Fund A Shares returned -1.03% at NAV, outperforming the -1.80% 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 A Shares. If included, it would reduce the performance quoted.

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

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 1.42% and the Russell 1000 Value Index returning -2.83%. In terms of asset allocation, the Russell 1000 Value Index underperformed the broader Bloomberg Barclays Aggregate Index as well as the Bloomberg Barclays Treasury Index.  The fund is overweight equities at 49.53% of its asset allocation relative to its neutral 40% equity index exposure. The equity relative overweight, which has helped performance since 2010, was a negative 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 Consumer Staples. The three sectors that most negatively contributed to fund performance were Consumer Discretionary, Telecom and Utilities.

On an absolute basis the five securities contributing most to fund performance were Texas Instruments, Intel, Motorola, Lam Research and Rexnord Conv. Pfd. The five positions detracting most from performance were CVS, Cimarex Energy, General Motors, Broadcom and Citigroup.

The fixed income portfolio returned -1.21% for the three months ended March 31, 2018 slightly underperforming the fund’s fixed-income blended benchmark return of -1.12%. The fund’s return significantly outperformed the Bloomberg Barclays Aggregate Bond Index, a commonly used barometer of performance for the broad high-quality bond market, which returned -1.46% during the quarter. Negative security selection concentrated in the high yield sector was the largest contributor to underperformance during the quarter. The fixed-income portfolio’s yield curve positioning, which ended the quarter neutral, and sector selection were a very slight negative contributors. The fund’s duration, which was less than the fixed income’s benchmark, was a relatively large positive contributor in the quarter but was unable to fully offset the other negative contributors.     

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 Industrials. The fund’s largest underweight positions include Financials, Energy and Utilities.

We continue to remain overweight high yield, EM and investment-grade corporates and underweight mortgage-backed securities. In terms of interest rates, our bias is still toward higher rates throughout the year, and as such we remain positioned with duration less than that of the benchmark.