As of 09-30-2018

Highlights

  • U.S. economic growth continued to accelerate, providing a strong backdrop for economically sensitive assets such as equities, high yield (HY) and investment-grade corporate (IG) debt. Globally, most economies also continued to expand but not at the pace of the U.S
  • Treasury yields generally rose across the curve even as the yield curve continued to flatten, with yields up approximately 30 basis points on the 2-year Treasury vs. only 20 basis points for the 10-year Treasury. Interest rate volatility increased meaningfully
  • Stronger growth and higher rates in the U.S., as well as trade tensions, caused the dollar to strengthen against most currencies, putting stress on a few emerging-market (EM) countries, most notably Argentina and Turkey, where a lot of foreign debt is funded in dollars

Looking Back

By almost any measure, growth within the U.S. economy accelerated at an impressive rate during 2018’s third quarter. The final read on second quarter gross domestic product (GDP) growth came in at 4.2%, well above expectations and the highest since 2014. The outlook for third-quarter GDP also remains strong, with expectations above 3%. Employment continued to expand with the unemployment rate falling to a low of 3.8%. Wages increased, with average hourly earnings rising 2.9% year-over-year, the fastest pace since 2009. Consumer confidence also at its multi-decade highs. Much of this robustness has been attributed to the tax cuts that took effect this year. This backdrop of faster economic growth, strong corporate earnings and relatively benign inflation proved favorable for economically sensitive financial assets, as the S&P 500 Index returned 7.71% for the quarter.

While economic data and financial asset performance was strong, it was not without periods of volatility, particularly in the month of August. Higher interest rates, a stronger dollar and renewed trade tensions created volatility within certain EM countries and in the foreign exchange markets. This volatility briefly spilled over into other sectors of the market. In Argentina, concerns about that country’s ability to refund its dollar-denominated debt created the need for the International Monetary Fund to provide support. Trade sanctions against Turkey and tariffs imposed against Chinese imports also caused their respective markets and currencies to trade off, contributing to global volatility. These pressures subsided somewhat in September, which saw a strong rally in the credit-sensitive sectors and led to strong returns for the quarter overall.

Finally the Federal Reserve (Fed) continued its gradual pace of increasing the fed funds target rate, hiking rates by another 25 basis points in September. The impact was generally felt more at the short-end of the yield curve, causing the yield curve to once again flatten. While the rate increase was small and widely expected, it was still enough to cause Treasury bonds to post a negative total return for the quarter. The Bloomberg Barclays U.S. Treasury Index had a 3-month return of -0.59%.

The HY bond market, as measured by the Bloomberg Barclays U.S. High Yield 2% Capped Index, returned 2.40% for the quarter. The positive nominal return represented an excess return of 2.48% relative to similar maturity Treasury bonds. The lower-rated B and CCC bonds outperformed higher quality BB bonds as default activity remains low. IG corporates also outperformed during the quarter. New issue activity in the corporate bond sector moderated as the new tax laws have allowed corporations to repatriate cash overseas with minimal tax consequence, reducing the need to issue debt.

Finally, EM debt as measured by the Bloomberg Barclays Emerging Market USD Aggregate Index returned 1.61 % for the three months. Argentina, Venezuela and Turkey were notable underperformers. However, there was no contagion to other countries in the sector as demonstrated by the strong relative performance.

Agency mortgage-backed securities (MBS) slightly outperformed U.S. Treasuries with a nominal return of -0.12% and an excess return of 0.17%.

Fund Performance

Federated Strategic Income Fund Institutional Shares had a total return at net asset value of 1.51% for the quarter, outperforming its blended benchmark’s return of 1.33%. The fund’s return also outperformed the Bloomberg Barclays Aggregate Bond Index, a commonly used barometer of performance for the broad high-quality bond market, which returned 0.02% during the quarter.

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

  • Portfolio duration maintained shorter than benchmark duration
  • Slight overweight position in domestic HY, EM and IG corporate sectors
  • Underweight position in MBS

Performance Detractors

  • Negative security selection within the equity holdings
  • Small currency positions in Australian and New Zealand dollars underperformed against the U.S. dollar

How We Are Positioned

We continue to expect the U.S. economy will remain robust over the short and intermediate term. That said, we also are mindful of certain trends occurring beneath the surface that could create headwinds for fixed-income assets down the road. These include a growing fiscal deficit, a potential shift in future inflation expectations, global trade issues and finally valuation levels of credit-sensitive securities.

The growing U.S. fiscal deficit has created a greater need for the government to borrow. At the same time, the Fed and soon the European Central Bank will be reducing their purchases of securities. Therefore, prices of Treasury securities may be impacted by less demand and growing supply. The concern would be that U.S. Treasury issuance could begin to crowd out other sectors of the market and create a greater-than-expected upward trajectory in interest rates. At this time, we feel that this risk is well recognized by the market, but bears watching.

The strong performance in the HY and IG corporate bond sectors during the quarter has reduced the risk premium, referred to as the spread over Treasuries, to new cycle lows and very close to historical lows. We expect corporate debt will generally outperform Treasuries, while the economy remains strong. However, returns will be more correlated to moves in interest rates and the potential for outperformance generally should be less than in past quarters.

We remain comfortable with our overweight to EM and domestic HY debt. Within our HY allocation, we have moved a portion of the portfolio into bank loans as spreads between secured debt and unsecured debt have compressed. We also think the floating-rate nature of the bank market will be attractive going forward. We also have marginally reduced our holdings of IG corporate debt in favor of U.S. Treasuries and developed international bonds. We continue to find Treasury Inflation-Protected Securities (TIPS) to be an attractive alternative to straight Treasuries. Finally, we believe that the strong dollar trend is nearing the end of its run and is likely to reverse going forward.