As of 09-30-2017

Market Overview

The Federal Reserve (Fed) did not increase short-term interest rate targets during the third quarter, but showed an inclination to continue its tightening bias at the upcoming December meeting, if a reading of the September Federal Open Market Committee (FOMC) meeting minutes provides any indication. An outline for the reduction of the Fed’s balance sheet was offered with a start date of October 2017, which will itself be a form of monetary tightening. Yet the minutes showed that the Fed was still optimistic about the U.S. growth and employment situation and that the recent weather disruption is unlikely to alter the economy’s course in the medium term. Furthermore, the Fed remained “confident that inflation will return back to the 2% target.” All in all, the tone of the release appeared to indicate a preference on the part of the Fed for an additional federal funds target rate hike in December.

The effect of this event on the bond market was an increase in rates from where they had been prior to the Fed meeting, with short-term yields increasing more than longer-term ones, a common reaction when the Fed is believed to be in a tightening mode. The yield on the 2-year Treasury note ended up increasing modestly, rising from 1.38% at June 30, 2017, to 1.49% at Sept. 30, 2017. The 5-year point of the Treasury curve increased less, from 1.89% to 1.94%, and the 10-year point increased only slightly, from 2.30% to 2.32%, over the reporting period.

With regard to credit metrics, spreads further out the maturity spectrum continued their tightening trend in the third quarter, with the Bloomberg Barclays Credit Index tightening from an option-adjusted spread of 103 basis points to 96 during the quarter (the level was 154 at Dec. 31, 2016). As has been the case all throughout 2017, shorter-dated credit performed better than longer credit (at least in terms of the amount of basis-point tightening), with the spread (option-adjusted) on the Bloomberg Barclays 1-3 year Credit Index tightening from 0.52% at June 30, 2017, to 0.44% at Sept. 30, 2017. The spread on the Bloomberg Barclays ABS Index, which at 2.28 years in duration represents a reasonable proxy for short-term spreads in securitized product, also tightened, from 0.46% at June 30, 2017, to 0.44% at Sept. 30, 2017. At this point, short-credit levels are either very close to or through their post-crisis tights (0.45% in May 2014 and 0.41% in December 2011 for the 1-3 Credit and ABS indices, respectively), though management continues to maintain a credit overweight in the portfolio. There is still room for spreads to tighten, however, as long as the economy continues to perform reasonably and foreign demand for yield continues, with the prospect of a tax-cut induced extension of the current economic cycle providing another potential (though not absolutely essential) catalyst.

Fund Performance

Federated Short-Term Income Fund’s return on Y Shares at NAV for the third quarter was 0.50%, versus a return of 0.48% on the Lipper Short Investment Grade Debt category average, a return on a composite of Merrill Lynch (ML) 0-3 Year Indices of 0.47% and a return on the Bloomberg Barclays 1-3 Year Government/Credit Index (BBC 1-3 G/C) of 0.34%. The maintenance of a shorter interest-rate risk profile relative to benchmarks and peers helped relative performance in a rising interest-rate environment. The fund’s bias toward credit risk also helped performance relative to higher-quality peers, though it lagged some competitors which utilized a significantly higher allocation to higher-beta assets (like noninvestment grade bank debt) which performed well during the quarter and skewed the peer category average upward (Y share performance fell at the exact median of the Lipper Short Investment Grade Debt category despite the shortfall relative to the average return statistic).

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.

Also click the Performance tab for standard fund performance.

Strategy

Stated fund duration was maintained over the course of the quarter in the 1.1–1.2 year range and ended the quarter at 1.2 years. Fund duration remains well below that of the 1.9 year duration on the BBC 1-3 G/C index or the composite index’s duration of 1.8 years, and current positioning reflects a belief that yields are likely to keep moving upward at the short-end of the yield curve during the remainder of 2017 and into 2018. The percentage of floating-rate debt in the portfolio was 52% (including cash balances) at Sept. 30, 2017, unchanged from last quarter. In terms of sector allocation, the asset-backed security (ABS) allocation decreased marginally from 37% of the portfolio last quarter to 36% at Sept. 30, 2017. Corporate exposure also saw a slight reduction, from 49% to 48% of the portfolio. The noninvestment-grade component remained at 7%. Both residential and commercial mortgage-backed securities (MBS) exposure remained essentially unchanged from last quarter, at 7% and 5%, respectively. Government exposure (excluding agency MBS) was flat at 2% of the portfolio, with cash equivalents increasing from 1% to 3%. The fund’s modest long position in 5-year Treasury futures was maintained during the quarter, bringing effective government exposure to 5% at Sept. 30, 2017. With regard to fund quality, cash, government and AAA-rated security exposure totaled 42% of the portfolio at Sept. 30, 2017, up from last quarter’s 40%. AA-rated exposure was 13% of the portfolio (down slightly from 14% at the prior quarter-end), and A-rated exposure fell from 19% to 17%. Total exposure rated below single-A increased slightly from 27% to 28% of the portfolio (21% in BBB-rated securities).

Click on the Portfolio Characteristics tab for information on quality ratings