Federated Municipal Ultrashort Fund (A) FMUUX

Share Classes Product Type Asset Class Category
Mutual Fund Fixed Income Muni National
As of 09-30-2017

Market Environment

Treasury yields rose modestly during the third quarter of 2017 amid indications of improving U.S. and global growth, heightened prospects for stimulative U.S. tax policy and the beginning of gradual balance-sheet reduction by the Federal Reserve (Fed). Continued low inflation and bouts of risk aversion related to potential conflict between the U.S. and North Korea offered countervailing downward pressure on market yields during the quarter. Two-year Treasury yields increased by 10 basis points, while 10-year and 30-year Treasury yields both increased by 3 basis points. Municipal bond yields followed a similar pattern, with steady inflows into municipal bond funds and modest new issuance supporting some outperformance for short- and intermediate-term municipal bonds relative to Treasuries. Municipal Market Data (MMD) 2-year AAA tax-exempt yields decreased 6 basis points, while the 10-year and 30-year AAA tax-exempt yields increased by 1 basis point and 5 basis points, respectively.

The Bloomberg Barclays Municipal Bond Index (BBMBI), the broad market index, posted a return of 1.06% 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 0.35% for the quarter. The 3-year component of the BBMBI (2-4 year maturities) returned 0.53%, the 5-year component (4-6 year maturities) returned 0.68%, the 10-year component (8-12 year maturities) returned 1.06% and the portion maturing in 22 years or more posted a return of 1.23%. The AAA-rated component of the BBMBI returned 0.71%, the A-rated component returned 1.23% and the BBB-rated component returned 2.79%.

While geopolitical, social and environmental turbulence dominated U.S. headlines in the third quarter, economic data largely avoided volatility and moderately improved. The progress was enough for the Fed in September to begin the long process of shrinking its massive balance sheet built up over years of quantitative easing. While the tapering that gets underway in October is modest, it symbolizes the end of a decade of extraordinary accommodation following the financial crisis. However, policymakers did not raise interest rates in the reporting period.

The third quarter was beset with vigorous debate in the U.S. over the removal of Confederate statues, the future of the Affordable Care Act, belligerent rhetoric by North Korea and the federal budget. But these were overshadowed by the ferociousness of enormous hurricanes that slammed Texas, Florida and the Caribbean in late August and September. Nonetheless, the U.S. economy continued to expand as business confidence rose, manufacturing accelerated, consumer sentiment improved and the labor market posted solid gains. Retail and auto sales disappointed and housing softened, but the overall narrative looking forward was positive.

In the equity markets, the major indexes repeatedly set new highs, bolstered by growth and expectations for tax reform. The corporate credit markets also performed well, while the Treasury yield curve flattened slightly. Subdued inflation remained an issue. Although various price gauges rose slightly in September, they remained below the Fed’s 2% target, in part due to wages not rising as much as has historically been the case in response to a tightening labor market.

During the three months ended Sept. 30, the 1-month London interbank offered rate (Libor) did not move materially, ending at 1.23%, while 3-month Libor rose from 1.30% to 1.33%. The 1-year MIG1 yield rose from 0.95% to 0.99%. The 7-day SIFMA Municipal Swap Index began the third quarter at 0.91%, dipped to 0.77% in mid-August, and then rose to 0.94% to end the quarter. The short end of the Treasury curve rose over the quarter, with 1-month and 3-month Treasury yields rising from 0.89% to 0.97% and 1.00% to 1.05%, respectively.

Performance

During the third quarter of 2017, the fund had total returns of 0.37% for the Institutional Shares (IS) and 0.26% for the Class A Shares at net asset value (NAV). Quarterly tax-exempt dividends also benefited from 0.10% of price appreciation as NAVs for both IS and A share classes increased by 1 cent, ending the quarter at $10.01 per share. The BB1MBI, the fund’s prospectus benchmark, returned 0.35% during the quarter.

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.

Click the Performance tab for standard fund performance.

Strategy

The fund’s duration started the third quarter at 0.35 years and ended it at 0.43 years as part of a tactical decision to keep the portfolio’s price sensitivity low. Management believed short-term municipal interest rates were likely to rise over the next 12 months as the Fed indicated a high probability of another 25-basis point tightening in interest rates coming in December, with several more in 2018. The Fed also is preparing for 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 (1.41 years), as this is consistent with the fund’s long-term strategy and prospectus limitation.

During the third quarter, yields for 2-year AAA-rated short-term municipal bonds moved downward before rising sharply in mid-September to close slightly higher on news the Fed is on track to normalize rates. The 2-year Treasury yield followed a similar pattern over the quarter. Two-year AAA-rated municipal yields started the quarter at a high of 1.06% and moved steadily downward in July and August to a low of 0.84% before rising sharply in September to end the quarter at 1.00%. As a result, 2-year municipal-to-Treasury yield ratios moved from 72% at the start of the quarter (fair value) to 62% (very rich) to 68% (slightly rich) at quarter-end. A lack of supply and strong demand for short-maturity municipal bonds resulted in the municipal outperformance. At quarter-end, the municipal yield curve from one to five years remained relatively flat, offering little incremental income per unit of risk (approximately 10 basis points per year) to extend duration, especially during a Fed tightening cycle.

Over the quarter, 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 30% of the duration of the BB1MBI, so the relatively unchanged level of short-term 2-year municipal interest rates over the quarter had little price effect.

From a security-selection perspective, floating-rate notes (FRNs), which comprised about 45% of the fund at the end of the quarter, outperformed in income relative to 1-year and 2-year maturity fixed-coupon bonds during the quarter and generally experienced continued price improvement. FRNs 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.

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 (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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Key Investment Team