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Despite a volatile June, U.S. equities closed slightly up on a total return basis in 2015’s second quarter. Points of investor focus during the quarter included Greece’s debt issues, a potential bond default by Puerto Rico, volatility in the Chinese economy and markets, and a rebound in U.S. economic data off a very slow first quarter. The second quarter also saw the reversal of major trends prevalent the previous two quarters, with oil prices rising 25% and the dollar index down.
On the domestic front, markets looked to bounce back from a weak first quarter that was slowed by inclement winter weather, West Coast port shutdowns, declining crude oil prices and a stronger dollar. While data in the second quarter was mixed, autos, manufacturing, consumer spending, employment and housing all showed signs of a spring bounce-back. Nonfarm payrolls were stronger than expected, with May’s increase of 280,000 making it 15 out of 16 months with more than 200,000 jobs being created (March 2015 being the exception). Additionally, housing exhibited strengthening momentum, with building permits—a good leading indicator—soaring to an 8-year high of 1.275 million units annually in May. Although the Federal Reserve (Fed) did not raise its target rate in June, it suggested continuing improvements in the economic data could inspire a liftoff as early as September.
Looking abroad, all eyes were on Greece as its longstanding debt issue came to a head at the end of the second quarter. The uncertainty involving a potential Greek default/exit from the eurozone and feared repercussions from such an outcome—namely, potential contagion to other euro periphery countries—added significant volatility to the markets. The S&P 500, for example, gave up nearly all of its quarterly gains, more than 2%, on the penultimate day of the quarter as the Greek saga dominated headlines. Fears of a default on Puerto Rican bonds and a slide in the Chinese stock market further added to investor uneasiness late in the quarter.
As the second half of 2015 begins, we expect ongoing volatility even as we remain optimistic on the U.S. economy. The labor market continues to be strong, with the unemployment rate at its lowest since May 2008, and there is potential for stronger GDP growth in the summer and fall months. The Fed should dominate the headlines, with an anticipated rate hike sometime during the second half. While the market debates the timing of the first rate increase in nine years, we believe the pace will be key to the markets moving higher. We expect the U.S. dollar to resume strengthening as the U.S. liftoff nears and uncertainty in Europe over Greece continues. We expect further mergers & acquisitions, dividend increases and share buyback announcements due to strong balance sheets and free cash flows from our companies and the persistent low interest rate environment. Globally, we are keeping a close eye on euro/Greece developments and the potential risks if Greece were to exit the euro. And to the East, we are closely watching China. Slower Chinese growth is influencing the rest of the region and the recent Chinese stock market sell-off has the feeling of a bubble bursting. We remain vigilant for opportunities globally as we adhere to our true-and-tested investment process to guide us through 2015’s volatile waters.
On the fixed-income front, U.S. Treasury rates increased across the yield curve over the course of the second quarter, reversing the first-quarter trend. The U.S. Treasury sell-off closely mirrored German Bund yields, which began the quarter at extremely low levels due to the commencement of the European Central Bank’s (ECB) quantitative easing program but moved up on better-than-expected European economic and inflation data. The Fed also acknowledged improvement in the U.S. economy during the quarter as it continued down the path toward its goal of normalizing monetary policy. While the Fed says it remains data dependent and will begin to raise the target funds rate when it sees further improvement in the labor market and is reasonably confident that inflation will move back to its 2% objective, Chair Janet Yellen emphasized following June’s policy-setting meeting that a rate hike is possible at any future meetings. She also stressed policymakers believe the actual date of the first rate hike was not as important as the pace of the subsequent hikes—a point reinforced by its latest projections, which revised lower the median target rate for 2016 and 2017 from 1.875% to 1.625% in 2016 and 3.125% to 2.875% in 2017. The median rate for this year was unchanged at 0.625%, suggesting one or two increases before year-end.
The markets for risk assets experienced increased volatility and wider credit spreads in the final week of June due to the potential Greece sovereign debt default. Higher U.S. Treasury rates and wider credit spreads resulted in negative second quarter total returns for the higher quality fixed-income sectors of U.S. Treasuries, investment-grade corporate bonds, U.S. mortgage-backed securities (MBS) and Commercial MBS. For the second quarter of 2015, the Barclays Treasury Index returned -1.58%, the Barclays Mortgage Index returned -0.74%, the Barclays Credit Index returned -2.88%, the Barclays High Yield Index returned 0.01%, and the Barclays Emerging Markets USD Aggregate Index returned 0.45%. In addition, the S&P 500 Index returned 0.28%, the Dow Jones Select Dividend Index returned -2.64% and the Barclays Aggregate Index returned -1.68%.
The fund met its primary goal of current income and long-term growth of income during second quarter 2015. The fund’s 12-month distribution yield for Class A Shares at the end of quarter was 5.43% net, with an SEC yield of 4.49%. The fund’s distribution yield is well above the S&P 500 yield at 2.05%; Dow Jones Select Dividend Index at 3.85%; 10 year Treasury yield at 2.35% and Morningstar Conservative Allocation at approximately 2.07%. The fund received three dividend increases during the second quarter including Hospitality Properties Trust, Kinder Morgan, and Principal Financial Group.
For the second quarter, Federated Capital Income Fund Class A Shares at net asset value returned -1.47%, underperforming the -1.12% return of the fund’s benchmark comprising of 40% Dow Jones Select Dividend Index, 20% BHY2%ICI, 20% BMB and 20% BEMB 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.
The fund’s second quarter performance within its class was impacted primarily by two factors 1) dividend stocks significantly underperformed growth within equities and 2) asset allocation overweight to equities relative to the fund’s neutral position.
During the quarter, within the equity markets, growth stocks outperformed dividend stocks, with the Russell 1000 Growth Index returning 0.12% while the Dow Jones Select Dividend Index returned -2.64%. The fund’s equity portfolio is diversified across qualified dividend income stocks and hence our style was impacted by this relative performance differential. In terms of asset allocation, Dow Jones Select Dividend Index underperformed the broader Barclays Aggregate Index and the Barclays Treasury Index. The fund is overweight equities at 50% of its asset allocation relative to its neutral 40% equity index exposure and class. The equity relative overweight, which has helped performance since 2010, was a relative negative contributor during the quarter.
In the equity portfolio, stock selection detracted from and sector weight added to the fund’s overall performance. Relative to the fund’s Dow Jones Select Dividend Index, the two best performing sectors were Utilities and Health Care. The two sectors that most negatively contributed to fund performance were Energy and Consumer Discretionary.
On an absolute basis the five securities contributing most fund performance were Newmont Mining (ELN), Lam Research (ELN), Abbvie, AT&T, and Lorillard. The five positions detracting most from performance were Frontier Communications, Hospitality Properties Trust, CenturyLink, GlaxoSmithKline and Superior Energy (ELN).
The fixed-income portfolio performed in line with the blended benchmark during the quarter, and outperformed the Barclays U.S. Treasury and U.S Aggregate indexes. The fund’s duration positioning, which was approximately 95% of its benchmark, and security selection were positive contributors to the fund performance during the quarter. The high-yield portfolio benefited from strong security selection in the Retail and Independent Energy sectors, while the Emerging Market (EM) portfolio benefitted from an overweight to corporate credits and positive country allocations. These positives were offset by the steepening of the U.S. Treasury curve, which negatively impacted the fixed-income portfolio’s flattening yield curve and long U.S. investment grade corporate positions.
Click on the Portfolio Characteristics tab for the fund’s top 10 holdings.
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.
Given some of the macro issues discussed above, 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 Dow Jones Select Dividend Index benchmark include Health Care, Information Technology, and Telecom Services. The fund’s largest underweight positions include Utilities, Energy, and Consumer Staples.
Similarly, within the fixed-income portfolio we believe the best opportunities currently are to remain overweight high yield, market-weight EM and underweight the higher quality markets relative to the fixed-income portfolio’s blended benchmark. The portfolio had an average effective duration of 4.2 years vs. the benchmark at 4.5 years. The fixed-income portfolio’s yield-curve positioning has been changed from a flattening bias to a neutral position.