Putnam municipal bond funds Q&A Q2 2013

Putnam municipal bond funds Q&A Q2 2013

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  PUTNAM INVESTMENTS | putnam.com Key takeaways •Municipalbond prices moved lower during the second quarter, as fears about the Federal Reserve tapering its stimulus program rattled the financial markets. •While a handful of states still face some budget pressure for the remainder of their 2013 fiscal year, 45 states reported that they are likely to meet or exceed their revenue projections for fiscal year 2013. •Interest-rate volatility and the longer-term prospect of higher rates have reinforced our bias toward a more limited duration stance. •We continue to overweight essential-service revenue bonds, as well as the A-rated and BBB-rated segments of the market. •Our outlook calls for defaults to remain low and continued gradual economic recovery. Economic growth, interest-rate volatility, and federal budget cuts created a complex environment during the second quarter. How did the municipal bond market perform? Heightened uncertainty on many fronts contributed to a mixed picture for the municipal bond market. During April, the municipal bond market followed the Treasury market to some extent, and benefited as rates moved lower and prices moved higher. However, in a notable sell-off from May into June, those gains were erased for the municipal market along with most fixed-income asset classes. Continued improvement in the U.S. economy raised concerns about the Federal Reserve paring back its stimulative bond-buying program, known as quantita- tive easing [QE]. Consequently, interest rates rose sharply, with the yield on the 10-year Treasury bond soaring close to 100 basis points, or a full percentage point, since the beginning of May. In June, technical pressures in the municipal market compounded the sell-off. Faced with the prospect of higher interest rates, many retail investors sold their municipal bond investments. Consequently, municipal bond funds experienced outflows that put further downward pressure on this asset class. On a positive note, with investor fears subsiding by period-end, June 27 marked one of the biggest one-day rallies in long-term municipal bonds since October 2008. Q2 | 2013 » Putnam municipal bond funds Q&A Rising bond yields outweighed progress in state finances, tax clarity Portfolio Managers Thalia Meehan, CFA (industry since 1983) Paul M. Drury, CFA (industry since 1989) Susan A. McCormack, CFA (industry since 1986)
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  Q2 2013 | Rising bond yieldsoutweighed progress in state finances, tax clarity PUTNAM INVESTMENTS | putnam.com 2 Despite volatility in the second quarter, we continue to see some encouraging trends across the municipal bond market. Refinancing activity has been high, as many issuers are retiring higher-coupon bonds whenever possible and replacing them with lower- yielding debt. While this trend makes it difficult to add higher-yielding securities to the portfolio, refinancing activity has simultaneously helped buoy prices and demand — seasonal weakness notwithstanding — and this has been true particularly for more seasoned, or mature, bonds with coupons above today’s prevailing rates. In addition, increased clarity on tax rates, at least for the near future, has had a positive influence on the market. Why did the markets react so strongly to the Fed’s statements? In early May, the Fed released a statement announcing that the central bank might consider reducing the amount of Treasuries and mortgage debt that it buys as part of its bond-buying program. This monetary stimulus program was designed to hold interest rates low to encourage employment and boost economic growth. However, the announcement, which also included a more upbeat assessment of the economy by the Fed, drove interest rates higher in anticipation of the Fed winding down the asset purchases. Initially, the municipal bond market withstood the rise in Treasury rates, but eventually municipal bond investors became nervous, and municipal yields moved higher as prices declined. More recently, at the June 19 Federal Open Market Committee meeting, Chairman Bernanke’s comments clarified that if the optimistic view of the economy’s progress proves to be correct, then a “tapering” of bond purchases may begin somewhat sooner than had been widely expected. While the Chairman was careful to stress that the Fed’s actions will be driven by the progress made by the economy, his remarks were widely seen as hawkish and led to a further rise in interest rates. Consequently, Treasury and municipal bond rates continued their sell-off before fears began to subside by quarter-end. How did sequestration and related legislation impact the municipal bond market? On March 1, 2013, the federal budget sequestration went into effect as part of January’s American Taxpayer Relief Act. While the political rhetoric associated with those cuts often has painted them as catastrophic, we believe any fallout for most states will be fairly benign. In our view, the cuts certainly won’t be beneficial for states and local communities, but their impact will be staggered over time. Thus, while we believe widespread negative effects are unlikely, isolated budget or insol- vency issues may create some headline risk. Sectors and localities that benefit most from federal support and areas that are heavily reliant on defense spending are the most vulnerable, in our opinion. But at this point, it is difficult to quantify exactly how sequestration will affect states’ finances. The ultimate impact will depend on how well these states have prepared and budgeted for the sequestration cuts. Outside of the sequestration issue, how are states’ finances faring today? Across the nation, states continue to make slow but steady progress as they emerge from the Great Reces- sion. While a handful of states still face some budget pressure for the remainder of their 2013 fiscal year, 45 states reported that they are likely to meet or exceed their revenue projections for fiscal year 2013, according to the National Conference of State Legislatures. While we believe this is an encouraging trend, challenges remain at the local level given federal deficit reduction and the ensuing cutbacks to the states. Many states have lowered expenses by reducing their financial support to cities and counties. Should the economy begin to slow, this reduced spending would almost certainly negatively affect municipal finances, in our opinion. However, on balance, we think the outlook is becoming increasingly stable, given the general improvement in employment, economic growth, and consumer confidence, all of which have contributed to rising tax collections.
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  Q2 2013 | Rising bond yieldsoutweighed progress in state finances, tax clarity PUTNAM INVESTMENTS | putnam.com 3 It is important to keep in mind that general obligation bonds, which are backed by the general credit and taxing power of state and local municipalities, compose approximately one third of the overall municipal market, while two thirds are revenue bonds. Generally speaking, we feel that revenue credits, which are typically issued by state and local governments to finance a specific revenue-generating project, are faring well. Among revenue bonds, we continue to see opportunities in sectors such as higher education, utility, and health-care bonds. How would you describe the general health of the municipal bond market? For calendar year 2012, bankruptcy filings represented approximately 0.12% of the $3.7 trillion municipal bond market. This default rate is in line with historical averages, and we do not believe defaults will increase meaningfully in the near future. We do expect to see occasional isolated incidents of insolvency, however, which can create headline risk. For example, in Michigan a fiscal emergency was recently declared in Detroit, which has been in financial distress for some time now, and Puerto Rico was downgraded by Moody’s and Standard & Poor’s. The government of Puerto Rico has since put in proposals for pension reform in an attempt to mend its credit profile. We are also closely monitoring the outcome of the bankruptcy proceedings in Stockton, California. That city filed for bankruptcy protection last summer, and the eventual outcome of the legal proceedings, with bondholders on one side and pension funds on the other, may set a precedent in the market, and could impact how other distressed cities negotiate with creditors. How did you position the funds during the quarter? As has been our strategy for some time, we continued to favor essential service revenue bonds over local general obligation bonds. From a credit-quality perspective, the A-rated and BBB-rated segments of the curve continue to offer attractive relative value opportunities, in our analysis. In terms of maturities, we find 10 to 20 years to be the optimal part of the yield curve in today’s envi- ronment. We continue to have a favorable outlook and have overweighted investments relative to the funds’ benchmark in several sectors of the municipal bond market, including continuing-care retirement communi- ties, utilities, and higher education. Generally speaking, the supply/demand picture becomes more favorable in the summer months when reinvestment demand is typically the highest of the year — thereby providing support for municipal bond prices. That said, other factors such as interest rates and the direction of the economy have and could continue to influence market activity. If we see a technical imbalance, we believe that our positioning should allow us to take advantage of any dislocations in the market. What is your outlook? We continue to have a constructive outlook for munic- ipal bonds, though we believe that returns in 2013 will be less about price appreciation and more about coupon income in the tax-exempt market. While the spreads are much narrower than they were at their peak, they remain attractive within certain credit-quality areas, in our opinion. Although they softened somewhat at the end of the period, technical factors in the market — specifically, continued refunding activity and stable investor demand — generally have remained supportive in recent months. While investors now have more near-term certainty on tax rates for 2013, many issues remain unresolved, including federal budget sequestra- tion, the debt ceiling, and the potential for broader tax reform later this year, all of which could affect the value of municipal bonds. As always, we are monitoring the situation closely and positioning the funds accordingly, based on our analysis.
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  Q2 2013 | Rising bond yieldsoutweighed progress in state finances, tax clarity The views and opinions expressed here are those of the portfolio managers as of June 30, 2013, are subject to change with market conditions, and are not meant as investment advice. Consider these risks before investing: Capital gains, if any, are taxed at the federal and, in most cases, state levels. For some investors, investment income may be subject to the federal alternative minimum tax. Income from federally tax-exempt funds may be subject to state and local taxes. Bond investments are subject to interest-rate risk (the risk of bond prices falling if interest rates rise) and credit risk (the risk of an issuer defaulting on interest or principal payments). Interest-rate risk is greater for longer-term bonds, and credit risk is greater for below-investment-grade bonds. Unlike bonds, funds that invest in bonds have fees and expenses. The fund may invest significantly in particular segments of the tax-exempt debt market, making it more vulnerable to fluctuations in the values of the securities it holds than a more broadly invested fund. Interest the fund receives might be taxable. Bond prices may fall or fail to rise over time for several reasons, including general financial market conditions and factors related to a specific issuer or industry. You can lose money by investing in the fund. Request a prospectus or summary prospectus from your financial representative or by calling 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. Putnam Retail Management | One Post Office Square | Boston, MA 02109 | putnam.com EO117 281763 7/13 Annualized total return performance as of June 30, 2013 Putnam Tax Exempt Income Fund (PTAEX) Class A shares (inception 12/31/76) Before sales charge After sales charge Barclays Municipal Bond Index Last quarter -3.40% -7.26% -2.97% 1 year 0.12 -3.88 0.24 3 years 4.82 3.40 4.46 5 years 5.03 4.18 5.33 10 years 4.10 3.67 4.42 Life of fund 6.70 6.58 — Total expense ratio: 0.75% Putnam Tax-Free High Yield Fund (PTHAX) Class A shares (inception 9/20/93) Before sales charge After sales charge Barclays Municipal Bond Index Last quarter -3.97% -7.81% -2.97% 1 year 1.57 -2.49 0.24 3 years 6.33 4.89 4.46 5 years 5.62 4.76 5.33 10 years 4.83 4.40 4.42 Life of fund 6.20 6.04 6.92 Total expense ratio: 0.82% Returns for periods less than one year are not annualized. Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or a loss when you sell your shares. Performance of class A shares after sales charge assumes reinvestment of distributions and does not account for taxes. After-sales- charge returns reflect a maximum 4.00% load. For purchases made after June 24, 2013, the 1% short-term trading fee, as described in the fund's prospectus, no longer applies. For Putnam Tax-Free High Yield Fund, the life-of-fund performance for class A shares is based on the historical performance of class B shares (inception 9/9/85), adjusted for the applicable sales charge. To obtain the most recent month-end performance, visit putnam.com. The funds’ expense ratios are based on the most recent prospectus and are subject to change. The Barclays Municipal Bond Index is an unmanaged index of long-term fixed-rate investment-grade tax-exempt bonds. It is not possible to invest directly in an index.