As of 03-31-2018

Highlights

  • Matched index return in quarter
  • Primary positive contributor to returns relative to the index was reduced interest-rate sensitivity (duration); sector allocation and yield-curve positioning were modest detractors
  • Fund positioned for rates to rise, credit sectors to outperform both Treasuries and government mortgage-backed securities (MBS)

Looking Back

The beginning and end of the first quarter of 2018 were in many respects mirror images of each other, driven in opposite directions by President Trump’s fiscal policy agenda. In January, investor euphoria over tax reform caused the stock market to surge, 10-year Treasury rates to rise to almost 3% and corporate bonds to outperform government bonds. But by March, fears of a trade war derailing the synchronized global growth upswing caused stocks to surrender all of the year’s gains, corporate bonds to underperform Treasury bonds and 10-year interest rates to fall back to 2.74% despite a 0.25% hike in the fed funds target rate by the Federal Reserve Bank (Fed).

Several other factors added to market volatility in the first quarter: (1) an expected first quarter slowdown in gross domestic product (GDP) growth from the 3% pace of the prior three quarters; (2) the transition from Janet Yellen to Jerome Powell as Fed chair; (3) uncertainty regarding whether or not wages and inflation would finally accelerate; and (4) a spike in short-term, Libor-based funding costs. Equities and the riskier, credit-oriented sectors of the bond market were further roiled by concerns that technology company profitability would be crimped by greater regulatory scrutiny; the fact market corrections are common in midterm election years; and increasing risk-free yields that began to offer an alternative to risky stocks or bonds for the first time in a decade. Finally, the Fed’s process of reducing its $4.5 trillion balance sheet, begun in October of 2017, started to gather momentum. Just as quantitative easing suppressed volatility in the years after the Great Recession, concerns about the Fed’s ability to smoothly manage this unprecedented era of quantitative tightening created additional uncertainty for the markets.

During the quarter the best-performing sector of the bond market was bank and trade-finance loans. The only other sector to outperform duration-equivalent Treasuries was emerging market (EM) bonds, by a small amount. Other taxable bond sectors lagged duration-equivalent Treasuries, including (in order of increasing underperformance): commercial MBS, high-yield bonds, asset-backed securities, government residential MBS, and investment-grade corporate bonds. Within the latter category, A-rated corporates surprisingly underperformed lower-rated BBB corporates, and financial institutions underperformed industrials and utilities. Investment-grade corporate bonds were the worst-performing sector due to a dearth of buying of shorter maturities by global corporations repatriating overseas cash due to the tax holiday, as well as significant issuance of long-term investment-grade bonds.

Performance

Federated Total Return Bond Fund Institutional Shares posted a total return net of fees of -1.43% for the quarter. The fund’s performance compares to a return of -1.46% for the Bloomberg Barclays U.S. Aggregate Bond (BBAB) Index. The fund’s total return for the period also reflected actual cash flows, transaction costs and other expenses that were not reflected in the total return of the BBAB Index.

Performance data 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 the Performance tab.

Click the Performance tab for standard fund performance.

Performance Contributors

  • Rates increased during a quarter in which the fund’s duration (interest-rate sensitivity) averaged about 90% of index duration
  • A 5% position in Treasury Inflation-Protected Securities (TIPS), security selection in EM bonds and an underweight to GNMA MBS
  • A combined 7% position in bank and trade finance loans, as well as an underweight to underperforming government MBS

Performance Detractors

  • An underweight to 30-year maturity bonds detracted modestly as buying from pension funds and insurance companies rebalancing out of equities cushioned the rise in long-term yields.
  • Losses from high yield and investment-grade corporate overweights.
  • Underperformance from select insurance and energy companies and underperforming long-term General Electric bonds.

Click the Portfolio Characteristics tab for information on quality ratings and the fund's top ten holdings.

How We Are Positioned

The fund begins the second quarter of 2018 with 90% of the interest-rate sensitivity (duration) of the index. Federated’s Duration Pod expects interest rates to move higher for three primary reasons. One, central banks globally are gradually reducing monetary stimulus in response to a synchronized growth upswing. Two, inflation is likely to creep higher due to tight labor markets, rising capacity utilization, a depreciating dollar and the Trump administration’s initiation of tariffs on a wide range of products. And three, Treasury supply is increasing dramatically in response to both tax cuts and increased spending in the budget bill, which are ballooning the federal deficit. The fund is laddered across the yield curve, with neither a steepening nor flattening bias. While Fed tightening regimes typically flatten the curve, rising federal deficits are usually associated with a steeper curve.

The fund has small overweights to high yield and EM bonds (6% and 4% of the fund, respectively), and a larger overweight to investment-grade corporates (37% of the fund). Profitability is increasing, tax reform should temper the upward creep in leverage by capping interest deductibility, default rates remain low, recession risks are minimal, bank lending standards have been loosening and recent stock market volatility has restored some degree of value by widening spreads to Treasuries. The fund is underweight government MBS. Fed buying of MBS will continue to decline as the Fed reduces its balance sheet, interest-rate volatility has increased, bank buying may subside as deposit growth stalls and Real Estate Investment Trust (REIT) buying is constrained by price-to-book ratios that do not currently support equity offerings. The fund added to its bank loan position (2% of the fund) and maintains close to 5% in trade-finance loans as these asset classes offer attractive yields with little interest rate risk. The fund has 21% in Treasuries primarily as a hedge against a significant stock market decline, potential trade war or other major risk-off event.

The fund has no non-dollar currency exposure. In terms of major security selection themes, the fund reduced its position in TIPS from 5% to 2.5%, taking profits on half its position. The fund is underweight GNMA MBS due to elevated prepayment risk and concerns that GSE reform may cheapen GNMA relative to FNMA and FHLMC MBS. The fund’s 2% allocation to commercial MBS is weighted toward AAA-rated tranches. The fund continues to hold 1% in municipal bonds. Within investment-grade corporates, the largest sector holding, the fund is overweight aerospace/defense, apartment REITs, brokers/asset managers, utilities, food/beverage, life and property/casualty insurers, media/entertainment, and integrated and midstream energy producers. The fund is underweight chemicals, health insurance and health care, independent energy producers, pharmaceuticals, restaurants, tobacco, and non-specialty retailers.

It should be noted that the fund employed derivatives during the quarter to help implement the duration, yield curve and credit-allocation strategies of Federated’s Alpha Pods. Investors should also be aware that government regulations have reduced the ability of dealers to warehouse bonds, resulting in potentially less liquid and more volatile bond markets in the future, which could impact the fund’s performance.