As of 12-31-2017

Market Overview

The U.S. economic expansion continued in the fourth quarter of 2017, aided by improving growth overseas and a generally more positive global economic outlook. The S&P 500 rose during the quarter and risk assets outperformed on a continued high level of optimism and the passage of tax reform in the U.S. The unemployment rate and the labor force participation rate both declined as payroll growth remained positive and average hourly earnings continued to rise. Companies continued to hold tightly to existing employees as new jobless claims remained low. Concern about the state of the U.S. economy and the ability of the current expansion to sustain momentum continued to abate as markets priced in higher growth due to expectations of lower taxes, less regulation and increased federal spending. Core Consumer Price Index (CPI) stabilized, but inflation remained somewhat below the Federal Reserve’s (Fed) target of 2%. Fed Chair Janet Yellen stated that she expects CPI to slowly rise in coming quarters toward the longer-term target. The Federal Open Market Committee (FOMC) raised the federal funds target rate to a range of 1.25-1.50% at its December meeting. Interest rates rose across the curve, with larger increases at the short end and a smaller increase at the 10-year point. The interest rate on the 30-year Treasury bond fell 12 basis points during the quarter. The FOMC implemented its previously announced plan to reduce the size of the Fed’s balance sheet over a period of years by gradually allowing a portion of its Treasury and mortgage-backed security holdings to roll off monthly without reinvestment, subject to certain caps on the pace.

Outside the U.S., the economic outlook continued to improve. Growth in Europe continued at a moderate pace, and the growth trajectory also improved in emerging markets such as China, Russia and Brazil. The fiscal position of the U.S. government continued to be troublesome. Previous budget deals stabilized domestic discretionary spending growth, but the long-term burden of rapidly growing entitlement spending had not been addressed. Total U.S. Treasury debt outstanding is over $20 trillion, more than the entire gross domestic product (GDP) of the U.S.

Treasury rates rose during the period for 10-year and shorter securities while interest rates on the 30-year Treasury bond fell. Mortgage securities outperformed similar-duration Treasuries. Within the coupon stack, 3% and 3.5% coupons outperformed 4% and higher coupons.

As of Dec. 31, 2017, the fed funds target rate range was 1.25-1.50%. The yield on 2-year Treasury securities rose 40 basis points to end the quarter at 1.88% and the yield on 10-year Treasury securities rose 7 basis points to end the quarter at 2.41%.

Fund Performance

For the three months ended Dec. 31, 2017, Federated Mortgage Fund (Institutional Shares) returned 0.15% versus 0.15% for the unmanaged Bloomberg Barclays U.S. Mortgage Backed Securities Index. The Institutional Shares’ net asset value (NAV) on Dec. 31, 2017, was $9.54.

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.

Duration management made a positive contribution to the fund’s performance as the fund maintained a below-neutral duration stance and yields rose during the period. The fund’s overweight to higher coupon mortgages, relative to 3% and 3.5% mortgages, detracted from fund performance as the lower coupon mortgages performed best during the quarter. The fund’s sector allocation did not make a material contribution to fund performance during the quarter as the fund reduced its out-of-index sector allocations.

Positioning and Strategy

The fund continues to keep a low allocation to non-government sectors as spreads have become very tight and we see less opportunity for outperformance. These sectors include non-agency-guaranteed mortgage-backed securities, non-agency-guaranteed commercial mortgage securities and asset-backed securities. Within the government sector, we maintained a balanced allocation between Ginnie Mae, Fannie Mae and Freddie Mac mortgage securities. The fund ended the fourth quarter with a below-neutral duration stance.