Federated Municipal Ultrashort Fund (IS) FMUSX

Share Classes Product Type Asset Class Category
Mutual Fund Fixed Income Muni National
As of 12-31-2017

Market Environment

Yields on short- and intermediate-term Treasury securities increased, while yields on long-term Treasury securities declined during the fourth quarter of 2017 amid ongoing moderate U.S. economic expansion, incremental tightening of monetary policy by the U.S. Federal Reserve (Fed), continued modest inflation and enactment of federal tax reform in December. Two-year and 10-year Treasury yields increased by 40 basis points and 7 basis points, respectively, while the 30-year Treasury yield decreased by 12 basis points. Municipal bond yields followed a similar pattern over the quarter after some bouts of volatility related to a record surge in municipal issuance late in the year ahead of the effective date for tax policy changes. The surge in supply was met with strong demand, thus allowing yields on intermediate- and long-term municipal bonds to decline more than was observed in the Treasury market. Municipal Market Data (MMD) 2-year AAA tax-exempt yields increased 56 basis points, while the 10-year and 30-year AAA tax-exempt yields decreased by 2 basis points and 30 basis points, respectively.

The Bloomberg Barclays Municipal Bond Index (BBMBI), the broad market index, posted a return of 0.75% for the quarter. The Bloomberg Barclays 1-Year U.S. Municipal Bond Index (BB1MBI), the fund’s prospectus benchmark containing only bonds maturing from one to two years, returned -0.38% for the quarter. The 3-year component of the BBMBI (2-4 year maturities) returned -0.77%, the 5-year component (4-6 year maturities) returned -0.70%, the 10-year component (8-12 year maturities) returned 0.52% and the portion maturing in 22 years or more posted a return of 2.23%. The AAA-rated component of the BBMBI returned 0.51%, the A-rated component returned 0.89% and the BBB-rated component returned 1.41%.

While uncertainties about a major tax overhaul and a flattening yield curve were in the forefront during the fourth quarter of 2017, the U.S. economy and its central bank provided a positive underpinning for the markets. Temporary distortion of data due to major hurricanes that hit various parts of the U.S. in late summer gave way to data showing many aspects of the economy on an upward trend. Gross domestic product appeared to hover around the strong 3% growth track experienced in the second and third quarters, a significant acceleration over the year-ago pace. The labor market continued to tighten, with unemployment falling and wages beginning to inch upward. Consumer spending was solid, with the combination of rising employment and robust confidence pushing holiday retail sales to 3-year highs. Business sentiment and manufacturing activity also improved, while the housing market shed its summer lull with a boost of late-year activity.

Although the news was welcome, the policy actions announced by the Federal Reserve (Fed) in the quarter were long in the making: the shrinking of its massive balance sheet of government and agency securities and another hike in interest rates. The reduction of its holdings began modestly, with $30 billion allowed to roll off its books in the quarter, but will increase in size over the coming quarters. December’s increase of rates, the third move in the year, raised the target range to 1.25% to 1.50% and was accompanied by an optimistic outlook for the economy in 2018 and a projection for three additional hikes in 2018. But policymakers remained troubled by the lack of inflation and the flattening of the yield curve, the latter occurring as the difference in rates between the short and long end of the Treasury curve decreased over the quarter. The reporting period ended in a flurry of activity in the U.S. municipal bond market as issuers and investors reacted to various GOP tax-reform proposals that could impact local and state governments as well as muni bond investors. President Trump signed the final bill into law in late December.

During the three months ended Dec. 31, 2017, the 1-month London interbank offered rate (Libor) rose from 1.23% to 1.56% and 3-month Libor rose from 1.33% to 1.69%. The short end of the U.S. Treasury curve also increased over the quarter, with 1- and 3-month Treasury yields rising from 0.97% to 1.25% and 1.00% to 1.45%, respectively.

The 7-day SIFMA Municipal Swap Index began the fourth quarter at 0.94% and held that level until jumping in December to end the quarter at 1.71% on year-end excess supply of variable-rate demand notes (VRDNs) and Fed tightening. The 1-year MIG-1 yield leapt from 0.99% to 1.46% due to higher rates and continued flattening with the market building in a case for three Fed hikes in 2018.


During the fourth quarter of 2017, the fund had total returns of 0.09% for the Institutional Shares (IS) and -0.02% for the Class (A) Shares at net asset value (NAV). Quarterly tax-exempt dividends were offset by -0.20% of price depreciation as NAVs for both IS and A share classes declined by 2 cents, ending the quarter at $9.99 per share. The BB1MBI, the fund’s prospectus benchmark, returned -0.38% during the quarter. For calendar year 2017, the fund had total returns of 1.16% (IS) and 0.71% (A) as the NAV moved up 1 cent to $9.99 per share. The BB1MBI returned 0.92% for calendar year 2017.

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. To view performance current to the most recent month-end and for after tax returns, click on the Performance tab. Performance does not reflect the maximum 2% sales charge for Class A Shares. If included, it would reduce the performance quoted.

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The fund’s duration started the fourth quarter at 0.43 years and ended at 0.49 years as part of a tactical decision to keep the portfolio’s price sensitivity low. Management believed short-term municipal interest rates likely were to rise over the next six to 12 months as the Fed tightened again in December, with several more planned for 2018. The Fed also is in the early stages of normalization of its massive balance sheet which could put some pressure on interest rates on the short and intermediate portions of the yield curve. The fund’s duration ended the quarter below the typical operating range of 0.5 to 1.0 years. This duration range remained well short of the fund’s benchmark index, the BB1MBI (1.39 years), as this is consistent with the fund’s long-term strategy and prospectus limitation.

During the fourth quarter, yields for 2-year AAA-rated short-term municipal bonds trended upward before rising sharply in mid-November and into December as the effects of the tax reform legislation spurred municipal issuers to rush to market before various issuance provisions were eliminated by year-end. Fourth quarter 2017 issuance was a record $145 billion, which created buying opportunities and relative cheapness versus taxable counterparts. During the quarter, the 2-year and 5-year AAA-rated municipal yields rose 54 basis points and 34 basis points, respectively, while 2-year and 5-year Treasury notes moved up 40 basis points and 27 basis points, respectively. During the quarter, 2-year municipal-to-Treasury yield ratios moved from a low of 66% (rich) in mid-October to a high of 86% (very cheap) in late November before ending the year at 81% (cheap). At quarter-end, the municipal yield curve from one to five years remained relatively flat, offering little incremental income per unit of risk (approximately 4 basis points per year) to extend duration, especially during a Fed tightening cycle.

Over the quarter and calendar year 2017, the fund’s gross and institutional share net returns beat the BB1MBI. The fund’s duration is always structurally short of the benchmark, ending the quarter at about 36% of the duration of the BB1MBI, so the increase in the level of short-term 2-year municipal interest rates over the quarter and calendar year benefited the fund versus the BB1MBI.

From a security selection perspective, floating-rate notes (FRNs) and VRDNs, which comprised about 41% and 23% of the fund at the end of the quarter, outperformed in income and total return relative to 1-year and 2-year maturity fixed-coupon bonds during the quarter. FRNs and VRDNs have coupons tied either to the 7-day municipal weekly reset SIFMA index plus a spread or a percentage of the 30-day Libor rate plus a spread. FRNs and variable-rate demand notes (VRDNs) benefit when the Fed is in a tightening cycle because their coupons increase as the base Libor and SIFMA indexes react to the Fed’s moves, as well as supply and demand factors in the municipal market. VRDNs also are stable value par instruments because of the demand feature and coupon reset.

We continued to look for high-income, relative-value opportunities along the front end of the yield curve. This included a core weighting to VRDNs (20% to 25% of the portfolio) and FRNs (40% to 45% of the portfolio) for both liquidity and core income, as well as 30-90 day commercial paper and tender bonds, fixed-rate notes (generally a year maturity at issuance) and a slight weighting to bonds with maturities generally inside of two years. The fund had low exposure to noninvestment-grade debt and did not use derivative instruments for hedging purposes. It did not have any exposure to Puerto Rico or any of its public corporations within the Commonwealth.

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