As of 09-30-2017

Market Overview

Interest rates fell in July and August and rose in September, ending the quarter slightly higher than where they started. Rates fell in the first two months of the quarter as U.S. inflation declined, the European Central Bank (ECB) backed away from tapering security purchases (causing European rates to drop and pressuring U.S. rates lower), investors became disillusioned with the Republicans’ ability to enact fiscal stimulus and North Korean missile tests prompted flight-to-quality buying of Treasuries (bond prices and yields tend to move in opposite directions). Ten-year Treasury rates started the quarter at 2.30% and traded as low as 2.02%. In September, rates reversed course and headed higher due primarily to five factors. First, purchasing manager indices indicated that global growth had entered a synchronized upswing. Second, central banks in most developed nations (excluding Japan) were either actively removing monetary policy accommodation or talking about removing accommodation. This included the Federal Reserve’s announcement that it would commence its highly expected balance-sheet drawdown in October and its signal that a potential December rate hike remained on the table. Third, consumer price inflation stabilized in the U.S. after five consecutive months of disappointing prints. Fourth, the outline of a tax-reform package released by the Trump administration revived hopes for fiscal stimulus. And fifth, reconstruction of hurricane damage was expected to boost U.S. gross domestic product (GDP). While risks of a North Korean conflict didn’t go away, the market seemed to become less sensitive to saber rattling on both sides. Ten-year Treasury rates ended the third quarter at 2.33%, slightly higher than levels at the start of the quarter.

All sectors of the taxable bond market outperformed comparable-duration Treasuries. Emerging-market (EM) bonds posted the best performance thanks to a rebound in commodity prices and stronger global growth. Other outperforming sectors, in order of excess returns over Treasuries, were high-yield bonds, investment-grade corporates, government mortgage-backed securities (MBS), commercial MBS (CMBS), asset-backed securities and trade finance loans. The credit sectors of the market continued to perform well due to rising corporate profitability, low and stable default rates, increasing global growth with little chance of recession near term, improving expectations for U.S. tax reform and buying from yield-hungry overseas investors. MBS also performed well as interest-rate volatility stayed at very low levels, reducing the value of the embedded prepayment option. MBS further benefitted from strong buying by Real Estate Investment Trusts (REITs).

Fund Performance

Federated Total Return Bond Fund Institutional Shares posted a total return net of fees of 0.94% for the quarter. The fund’s performance compares to a return of 0.85% for the Bloomberg Barclays U.S. Aggregate Bond Index.

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.

The main reason for the fund’s outperformance relative to the benchmark was sector allocation, in particular an overweight to high yield and investment-grade corporate bonds. A 3.4% allocation to EM bonds also benefitted performance, as did an underweight to Treasuries. Not all sector allocation themes worked, as an underweight to MBS subtracted from returns. Duration was another positive contributor, as the fund had less interest-rate sensitivity than the index during a quarter in which interest rates rose modestly. A short position in German bonds also added to performance. Yield-curve positioning detracted from returns due to an underweight to intermediate maturities early in the quarter. Currency had little impact on returns; a position long the U.S. dollar and short a basket of developed nation currencies initially lost value, then rebounded to unchanged by quarter end. Security selection was mixed but overall slightly positive. Winning themes included an overweight to BBB investment-grade corporates relative to higher-rated corporates, an overweight to 30-year MBS relative to 15-year MBS, a 3% position in Treasury Inflation-Protected Securities (TIPS), and a rebound in several investment-grade energy issuers. Detracting from security selection returns were an overweight to higher-coupon MBS which underperformed lower-coupon MBS, a pair of trade finance loans, and a small position in Teva Pharmaceuticals.

Click on the Portfolio Characteristics tab for information on quality ratings.

Positioning and Strategy

The fund begins the fourth quarter of 2017 with approximately 92% of the interest-rate sensitivity (duration) of the index. Federated’s Duration Pod expects interest rates to move higher as central banks globally gradually reduce monetary stimulus, global economic growth accelerates, U.S. tax reform gains momentum, and inflation is nudged higher by a weaker dollar and tighter labor market. Reducing interest-rate risk also seems prudent given that the duration of the aggregate index is at an all-time high, while the yield of the Index remains near an all-time low. Part of the duration reduction is expressed in a short position in German 10-year bonds, where levels well under 1% are inconsistent with accelerating economic growth in Europe. In terms of the yield curve, the fund removed its underweight to intermediate maturities. The fund’s maturity allocation is now approximately equivalent to the index maturity allocation. While the yield curve typically flattens when the Fed is raising rates, the potential for tax reform could cause the yield curve to steepen in the intermediate term; thus, the fund is approximately neutral relative to the index.

The fund remains overweight high yield and investment-grade corporate bonds. While spreads have tightened significantly in recent quarters and the value proposition is less attractive, an environment of low volatility, rising equity markets, gradual central bank removal of accommodation and diminished recession risk all argue for retaining an overweight to the credit sectors. The fund has a 37.7% position in investment-grade corporate bonds, 6.6% in high-yield bonds, 3.4% in primarily dollar-denominated EM debt, and 1.6% in CMBS. The fund also holds 4.7% in trade finance loans and 1.7% in bank loans, both of which offer attractive yields with little interest-rate risk. The fund remains underweight government mortgages (18.3% vs. 28.1% of the index). The Fed will begin winding down its MBS reinvestment program this quarter, spreads to Treasuries are rich and interest-rate volatility is unlikely to fall much from already depressed levels. The fund is underweight Treasuries, but still has 23.3% of the fund in this sector as a hedge against an unforeseen risk-off event.

In terms of currency exposure, in September the fund initiated a small U.S. dollar long position against a basket of developed market currencies (euro, Canada, Australia, New Zealand and Japan). Given the 10% decline in the value of the trade-weighted dollar year-to-date, Federated’s Currency Pod anticipated a reversal given improved prospects for U.S. growth relative to other countries.

In terms of major security selection themes, the fund has begun to reduce its large overweight to BBB corporates given the significant gains from this position in recent years. The fund retains a 3% position in TIPS, and is underweight GNMA MBS due to prepayment concerns. Within investment-grade corporates, the largest sector holding, the fund is overweight aerospace/defense, apartment REITs, brokers/asset managers, utilities, food/beverage, life and property/casualty insurers, media/entertainment, technology and integrated energy. The fund is underweight construction machinery, gaming, health care, pharmaceuticals, tobacco and non-specialty retailers.

It should be noted that the fund employed derivatives during the quarter to help implement the duration, yield-curve and credit allocation strategies of Federated’s Alpha Pods. Investors should also be aware that government regulations have reduced the ability of dealers to warehouse bonds, resulting in potentially less liquid and more volatile bond markets in the future, which could impact the fund’s performance.