As of 12-31-2017

Highlights

  • Outperformed index in quarter
  • Sector allocation, interest-rate positioning and security positioning largest contributors to outperformance
  • Fund positioned for rates to rise, curve to steepen, credit sectors to outperform both Treasuries and government mortgage-backed securities (MBS)

Looking Back

Interest rates for the most part rose in the fourth quarter, particularly shorter maturities in response to a hike in the overnight federal funds rate by the Federal Reserve (Fed). Two-year Treasury rates, for example, rose from 1.48% to 1.88%. The longest maturity interest rates, by contrast, fell slightly despite the Fed’s decision to buy fewer government bonds as inflation remained surprisingly quiescent. Thirty-year Treasury yields declined from 2.86% to 2.74%.

In addition to the Fed’s hike, most rates moved higher in response to stronger economic growth, which the market expects will trigger additional tightening by the Fed. After several years mired at 2%, gross domestic product (GDP) growth in the U.S. accelerated to 3% thanks in large part to improving business and consumer sentiment driven by expected (and ultimately realized) tax cuts, reduced government regulations and hopes for infrastructure spending in coming quarters.

As mentioned, one of the more surprising developments in 2017 was the fact that inflation failed to materialize at the consumer level, despite a 4.1% unemployment rate, rising commodity prices, a weaker dollar and an uptrend in core producer prices. Prices have been restrained by intense global competition, technological advances such as internet price discovery, and an aging population base. Wages, historically correlated to inflation, have also been slow to rise, as employee bargaining power has been undermined by threats of off-shoring jobs, the rise of robots and other job-eliminating technologies, and the lingering psychological impact of the Great Recession. A key question for the bond and stock markets in 2018 will be whether inflation finally lifts off and how the Fed responds to whatever path inflation takes. Low inflation has enabled the Fed to raise interest rates at a very slow pace; indeed, the federal funds target rate remains below most estimates of inflation. This has supported stock and corporate bond markets and kept longer interest rates lower than historical norms.

All sectors of the taxable bond market outperformed comparable-duration Treasuries in the fourth quarter. Investment-grade corporates were the best-performing asset class measured by excess return over duration-equivalent Treasuries. Other outperforming sectors, in order of excess return performance, were emerging-market (EM) bonds, commercial MBS, high-yield bonds, government MBS, asset-backed securities and trade-finance loans. The credit sectors of the market continued to perform well due to strong equity markets, rising corporate profitability, low and stable default rates, increasing global growth with little chance of recession near term, a significant cut in the U.S. corporate tax rate, moderately looser bank lending standards, and buying from yield-hungry overseas investors.

Performance

Federated Total Return Bond Fund Institutional Shares posted a total return net of fees of 0.60% for the quarter. The fund’s performance compares to a return of 0.39% for the Bloomberg Barclays U.S. Aggregate Bond Index (BBAB). 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

  • Interest-rate exposure ranged from 90-92.5% of the index during a period in which interest rates rose, resulting in less price depreciation than the index experienced
  • A bias for longer-maturity bonds to outperform shorter-maturity bonds in November (a yield curve “flattener”)
  • Overweights to high yield and investment-grade corporates
  • A 3% to 5% allocation to Treasury Inflation-Protected Securities (TIPS), which outperformed nominal Treasuries despite little movement in core inflation

Performance Detractors

  • An underweight to government MBS, which outperformed similar duration Treasuries due primarily to very low levels of interest-rate volatility
  • Select corporate holdings, including Teva Pharmaceuticals and Century Link

How We Are Positioned

The fund begins the first quarter of 2018 with 92.5% of the interest-rate sensitivity (duration) of the index. Federated’s Duration Pod expects interest rates to move higher as central banks globally gradually reduce monetary stimulus, global economic growth accelerates (aided in the U.S. by tax reform and reduced regulatory burden on businesses), the Fed continues to gradually hike the federal funds target rate, and as a weaker dollar and tighter labor markets begin to push inflation higher. Reducing interest-rate risk relative to the BBAB Index also is prudent given that the duration of the index is near an all-time high, while the yield of the Index remains near an all-time low. Part of the duration reduction is expressed in a short position in German 10-year bonds, where levels well under 1% are inconsistent with accelerating growth in Europe and reduced bond purchases by the European Central Bank. In terms of the yield curve, the fund took profits on a flattening trade and moved to a tactical steepener anticipating a short-term reversal of the large flattening move during 2017.

The fund remains overweight high yield and investment-grade corporate bonds. While spreads continue to tighten and are below long-term averages, there does not appear to be any catalyst on the horizon to cause these sectors to underperform lower-yielding Treasuries. The risk of recession is minimal, central bank removal of accommodation is progressing at a very slow pace, defaults remain low, bank lending standards have loosened, and corporate tax cuts should boost profitability and potentially reduce supply. The fund further reduced its position in government mortgages as the Fed will buy progressively fewer MBS in 2018, valuations are very rich and interest-rate volatility is unlikely to fall much from already depressed levels. The fund is underweight Treasuries, but still has 22% of the fund in this sector as a hedge against an unforeseen risk-off event. The fund slightly increased its EM bond position to 3.9%, reflecting an upbeat view of global growth prospects and commodity prices.

The fund has very little non-dollar currency risk. In terms of major security selection themes, the fund reduced its large overweight to BBB corporates given the significant gains from this position in recent quarters. The fund increased from 3% to 5% its position in TIPS. The fund is underweight GNMA MBS due to prepayment concerns. The fund added a 1% position in municipal securities to take advantage of cheapening in this sector due to a deluge of supply at year-end. Within investment-grade corporates, the largest sector holding, the fund is overweight aerospace/defense, brokers/asset managers, utilities, food/beverage, life insurers, media/entertainment, integrated energy, refiners, and supermarkets. The fund is underweight chemicals, gaming, health care, pharmaceuticals, 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.