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Equity markets finished the second quarter of 2016 slightly positive despite several jolts of volatility. The looming U.S. presidential election and negative global interest rates generated uneasiness, but by far the biggest market-moving event of the quarter was the United Kingdom’s Brexit vote to leave the European Union (EU).
On the domestic front, a lot of attention was paid throughout the quarter to monthly economic data with the thought the Federal Reserve (Fed) could raise the fed funds target rate another one or two times this year, with June being a real possibility. However, a weak May nonfarm payroll report derailed any chance for a June rate hike. Despite weak manufacturing numbers and mixed consumer sentiment, GDP rebounded in the quarter on improving housing, consumer spending and inventory data and more robust business activity.
Looking abroad, the yield on German 10-year bonds turned negative for the first time ever on fears of the Brexit vote as well as continued quantitative easing by the European Central bank. Brexit fears became reality in late June as the “leave” vote won by a small majority, although it was technically a non-binding referendum. The referendum now sets in motion a long process to leave the EU. Brexit has left investors anxious about other countries potentially leaving the EU, as well as about any economic and financial fallout from the U.K’s exit.
As we look to the third quarter of 2016 and beyond, we expect market volatility to continue and most likely increase. The results of the Brexit referendum are just starting to work through the global markets. We would not be surprised if there are additional bouts of volatility as assets around the world are re-priced. We believe the large downward move in the British pound, reigniting U.S. dollar strength, could lead to knock-on effects across the markets and negatively impact multinationals’ profits that were expected to see a tailwind from a weaker dollar. In addition to Brexit being digested, the U.S. presidential election will take center stage in the third quarter, which always creates market angst. The Fed will continue to keep an eye on both inflation that remains persistently below its 2% target and the labor market to see if the trend toward slowing job growth continues. The question of full employment and wage pressure is likely to surface, which could be the necessary ingredient to drive inflation and with it a rate hike. At this point, given relative market valuations, we believe a balanced portfolio of cyclical and defensive companies that have strong cash flow, balance sheets and improving fundamentals will help weather through expected market volatility.
The second quarter was a strong total return period for all of the major U.S. fixed-income markets, due to the combination of declining U.S. Treasury yields and tighter credit spreads. The surprise Brexit vote created a demand for higher quality assets, added to downward pressure so U.S. Treasury yields already being impacted by negative yields on 10-year sovereign bonds in Japan and Germany. Indeed, over the course of the quarter, U.S. Treasury rates declined for every maturity of six months or longer, with the largest declines occurring on the longest end of the yield curve. Specifically, the yield on the 30-year maturity declined by 33 basis points in the quarter to 2.28%, while the total return of the Barclays US Treasury index in the second quarter was 2.1%. Despite the volatility in the quarter and the demand for haven assets, the relatively attractive yields in the U.S. resulted higher credit spreads across high yield, investment-grade corporate and emerging-market sectors.
For the second quarter of 2016, the Barclays Aggregate Index returned 2.21%, the Barclays Treasury Index returned 2.10%, the Barclays Mortgage Index returned 1.11%, the Barclays Commercial Mortgage Index returned 2.24%, the Barclays Investment Grade Corporate Index returned 3.57%, the Barclays High Yield 2% Issuer Capped Index returned 5.52% and the Barclays Emerging Markets USD Aggregate Index returned 4.67%. In addition, the S&P 500 Index returned 2.46%, the Dow Jones Select Dividend Index returned 5.40% and the Russell 1000 Value Index return 4.58%.
The fund met its primary goal of current income & long-term growth of income during second quarter 2016. The fund’s 12-month yield for A Shares at Net Asset Value (NAV) at end of quarter was 4.95% net, with an SEC yield of 3.55%. The fund’s yield is well above the S&P 500 yield at 2.09%; Dow Jones Select Dividend Index at 3.66%; 10 year Treasury yield at 1.47% and Morningstar Conservative Allocation average at approximately 2.25%. The fund received 15 dividend increases during the second quarter including Apple, Johnson & Johnson, and MetLife.
For the second quarter, Federated Capital Income Fund A Shares at NAV returned 2.70%, underperforming the 4.42% 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 dividend stocks outperforming growth stocks.
During the quarter, within the equity markets, dividend stocks outperformed growth stocks. For the quarter, the Dow Jones Select Dividend returned 5.40% while the Russell 1000 Growth Index returned 0.61%. In terms of asset allocation, the Dow Jones Select Dividend Index outperformed the broader Barclays Aggregate Index and the Barclays Treasury Index. The fund is overweight equities at 45% 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 positive contributor during the quarter.
In the equity portfolio, stock selection added to while sector weight detracted from the fund’s overall performance. Relative to the fund’s Dow Jones Select Dividend Index, the three best-performing sectors were Financials, Consumer Discretionary and Consumer Staples. The three sectors that most negatively contributed to fund performance were Health Care, Energy and Information Technology.
On an absolute basis the five securities contributing most fund performance were Post Holdings (Conv. Pfd.), Dynegy (Conv. Pfd.), GlaxoSmithKline, Hospitality Properties, and Altria. The five positions detracting most from performance were Allergan (Conv. Pfd.), Microsoft, Gilead Sciences, CenturyLink, and MetLife.
Click on the Portfolio Characteristics tab for the fund’s top ten holdings.
The fixed-income portfolio return of 3.23% underperformed its blended benchmark by 88 basis points during the second quarter, but materially outperformed the higher quality Barclays U.S. Treasury and Barclays U.S. Aggregate indices by 113 and 102 basis points, respectively. Sector was the largest positive contributor to performance due to high yield and emerging market overweights. Security selection was the largest negative contributor to performance. The negative impact from security selection was primarily focused in the high-yield portion of the portfolio, which was underweight the better-performing commodity sensitive credits. The impact of interest rates on the portfolio was slightly negative due to the fund’s duration position, which was approximately 97% of the fixed-income blended benchmark’s duration for a majority of the quarter.
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.
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 sheet 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 Information Technology, Health Care and Financials. The fund’s largest underweight positions include Utilities, Materials and Consumer Discretionary.
The fixed-income portfolio remains slightly overweight high yield, neutral emerging markets and underweight the higher quality corporate and mortgage markets relative to the fixed-income portfolio’s blended benchmark. The portfolio had an average effective duration of 4.07 years versus the benchmark at 4.18 years. The fixed-income portfolio is positioned with a flattener relative to the yield curve.