As of 06-30-2017

Market Overview

In the second quarter of 2017, equity markets continued to drift higher in a low volatility environment as investors pinned their hopes on eventual passage of the Trump administration’s pro-growth initiatives. The health-care bill has been the speed bump as it slowly wound its way through the Senate, but had still not been voted on as the quarter closed. Global economic growth drove international equity markets higher in the second quarter, as well.

On the domestic front, the technology-heavy Nasdaq Composite Index led U.S. equity markets during the spring quarter. Despite June’s pullback, tech stocks were the main driver for the index, which rose almost 4% in the quarter. Other U.S. equity markets trudged higher as investors looked past gridlock and remained hopeful that lower taxes and reduced regulation for U.S. corporations eventually would be implemented. The Federal Reserve (Fed) once again was a factor, raising the fed funds target rate 25 basis points in June for the third time in six months and signaling another rate hike, and the beginning of a gradual balance-sheet reduction program is likely before year-end. While some economic data disappointed, employment continued to remain strong, with the unemployment rate back to pre-crisis lows.

Looking abroad, emerging markets (EM) led the way for international stocks as a weaker U.S. dollar provided a boost during the quarter. Though not as strong as the EM, developed markets also carried over momentum from the first quarter to post positive returns.

The third quarter of 2017 looks to start much the way the second quarter did, with the market looking for progress on the Trump agenda, mainly health care and tax cuts. We do expect some clarity soon as the 2018 federal budget cannot be passed until the 2017 reconciliation is closed, which is attached to health-care bill currently being debated. Due to Washington’s political divide, we expect tax cuts and not tax reform to take center stage sometime in August or September. In addition to the Washington, D.C.-driven headlines, we also expect the Fed to influence the markets. While expectations for another rate hike and balance-sheet reductions are known events to the market, we would expect some volatility when the Fed actually starts to pare its balance sheet, hopefully without triggering another taper tantrum. We also expect 2017’s strong earnings to continue when second-quarter results start arriving in mid-July. Another good reporting season could continue to propel the market, even in the face of the political uncertainty. Given relative market valuations, which no longer are 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 current investment landscape.

In fixed income during the second quarter, U.S. Treasury rates increased the most on the front end of the yield curve while longer rates declined. Specifically, rates for 1-month to 1-year maturities increased 11 and 26 basis points, respectively, compared to respective declines of 8 to 18 basis points for 10- and 30-year Treasuries. As a result, the U.S. Treasury curve substantially flattened during the reporting period, aided in part by a typical market reaction to target fund increases. At its June meeting, Fed policymakers acknowledged softness in inflation but viewed the decline as transitory, citing a decline in the price of some telecommunications plans and lower drug prices. As a result, the Fed’s outlook for future rate increases was unchanged for 2017 and 2018, and just down slightly for 2019. The central bank also detailed future plans to reduce its bloated balance sheet, saying reductions will start at $10 billion a month and grow by an additional $10 billion quarterly until it reaches a maximum of $50 billion.

Despite lower long yields over the course of the quarter, long yields did begin to move up toward quarter-end. This was driven by hawkish commentary out of the European Central Bank (ECB), which put upward pressure on German yields, which in turn put upward pressure on U.S. Treasury yields as the market anticipated the era of extraordinary global monetary accommodation may be ending. Despite the weaker end to the quarter, all fixed-income asset classes reported positive total returns for the three months, led by high yield and EM bonds, with high-yield spreads relative to comparable-maturity Treasuries tightening slightly.

For the second quarter, the total return for the Bloomberg Barclays US Treasury Index was 1.19%, compared to 2.17% for the Bloomberg Barclays U.S. High Yield 2% Issuer Capped Index. Also, the Bloomberg Barclays Aggregate Index returned 1.45%, the Bloomberg Barclays Mortgage Index returned 0.87%, the Bloomberg Barclays Commercial Mortgage Index returned 1.31%; the Bloomberg Barclays Investment Grade Corporate Index returned 2.54% and the Bloomberg Barclays Emerging Markets USD Aggregate Index returned 1.77%. In addition, the S&P 500 Index returned 3.09% and the Russell 1000 Value Index return 1.34%.

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 3.85% at quarter-end, with a 30-day SEC yield of 2.89%. The fund’s yield was above the S&P 500 dividend yield at 1.90%; Russell 1000 Value Index at 2.34%; 10-year Treasury yield at 2.30% and Morningstar Conservative Allocation average at approximately 2.20%. The fund received more than 15 dividend increases during the second quarter, including PNC, Caterpillar and Apple.

For the second quarter, Federated Capital Income Fund A Shares returned 0.94% at NAV, underperforming the 1.51% 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 as the Russell 1000 Growth Index returned 4.67% while the Russell 1000 Value Index returned 1.34%. In terms of asset allocation, the Russell 1000 Value Index underperformed the broader Bloomberg Barclays Aggregate Index but outperformed 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 negative contributor during the quarter.

In the equity portfolio, stock selection detracted from while 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 Industrials, Real Estate and Utilities. The three sectors that most negatively contributed to fund performance were Consumer Discretionary, Consumer Staples and Energy.

On an absolute basis the five securities contributing most to fund performance were Citigroup, Allstate, Quest Diagnostics, Corning and East West Bancorp. The five positions detracting most from performance were Nabors Industries, Ensco PLC, Conagra Brands, AT&T and Baker Hughes.

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

The fixed-income portfolio return of 1.62% outperformed its blended benchmark by 1 basis point during the quarter and slightly outperformed the higher-quality Bloomberg Barclays U.S. Treasury and Bloomberg Barclays U.S. Aggregate indices by 43 and 17 basis points, respectively. Security selection was the largest positive contributor to performance, due primarily to positive security selection in the high-yield portion of the portfolio. Sector allocation was a slight positive contributor to performance due to the overweight to high yield. Duration and yield curve were negative contributors to performance due to being on average 89% of the fixed-income blended benchmark’s duration as long yields fell and the yield curve flattened.

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, Utilities and Energy.

The fixed-income portfolio remains slightly overweight high yield, neutral in 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 3.77 years versus the benchmark at 4.22 years. The fixed-income portfolio is positioned neutral relative to the yield curve.