Putnam Perspectives: Fixed-Income Outlook Q3 2014

Putnam Perspectives: Fixed-Income Outlook Q3 2014

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  Putnam fixed-income views Arrowsin the table indicate the change from the previous quarter. Underweight Smallunderweight Neutral Smalloverweight Overweight Fixed-income asset class U.S. government and agency debt l U.S. tax exempt l Tax-exempt high yield l Agency mortgage-backed securities l Collateralized mortgage obligations l Non-agency residential mortgage-backed securities l Commercial mortgage-backed securities l U.S. floating-rate bank loans l U.S. investment-grade corporates l Global high yield l Emerging markets l U.K. government l Core Europe government l Peripheral Europe government l Japan government l CURRENCY SNAPSHOT Dollar vs. yen: Dollar•Dollar vs. euro: Dollar•Dollar vs. pound: Pound Broad-based economic improvement supports risk assets Now at midyear, the global outlook looks bright. Indeed, the shift in the global econ- omy’s momentum between the first and second quarter appears to have been quite sharp. Some of this, of course, reflects the U.S. recovery from the weather-related slow- down in the first quarter, but the acceleration is more broad-based. Among advanced economies, the United States and the United Kingdom look strikingly better, while Japan looks stronger at this stage than many people expected. Europe does not look much better, but it doesn’t look any worse, either. Across emerging markets, the economic outlook is a mixed bag, with some countries improving and others appearing poised to do worse, but, at the margin, EM is contributing to the global expansion. China appears to be moderately stronger, thanks to the targeted stimulus measures taken over the past few months. The window to normalize is open Importantly, most central banks appear happy to keep the stimulus flowing, and as a result, risk assets had a strong quarter through June. The performance of risk assets against a global economic backdrop that remains uneven and harbors significant downside potential has led to renewed concern about whether asset markets are adequately pricing risks. Some observers believe that central banks should begin normalizing rates soon, to take advan- tage of the window of opportunity presented by the current pickup in global growth. Key takeaways • The global economy is improving overall, with the U.S. and U.K. leading the way. • We expect higher GDP growth from the U.S. to support risk assets in the third quarter. • We continue to expect a rise in U.S. interest rates in 2014, though eurozone policy may help slow a near-term increase. • We favor credit, prepayment, and liquidity risks, which we express in allocations to mezzanine CMBS, peripheral European sovereigns, select EM sovereigns, and interest-only (IO) CMOs. Q3 2014 » Putnam Perspectives Fixed-Income Outlook D. William Kohli Co-Head of Fixed Income Michael V. Salm Co-Head of Fixed Income Paul D. Scanlon, CFA Co-Head of Fixed Income
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  2 Q3 2014 | Fixed-Income Outlook The Bankof England may be the first to act. The BoE has acknowledged that a rate increase is on the horizon and has introduced macro-prudential measures to address housing-market risks. The measures, which include stricter affordability tests for borrowers and restrictions on loan-to-value ratios for loans that are a high multiple of borrowers’ incomes, pose an interesting experiment that bears scrutiny. U.S. inflation picking up, Euro inflation bottoming In the United States, economic data surprised to the upside in the second quarter, including in purchasing managers’ indexes, labor market dynamics, auto sales, and a variety of housing-market metrics. However, food costs are contributing positively to inflation, largely because the drought in California has pushed up fruit and vegetable prices, while cost trends in the housing sector have contributed to core inflation levels. U.S. policy tends to look through the food-related cost pressure as it focuses on core inflation, which excludes the volatile food and energy components. Moreover, the Fed uses the PCE deflator — personal consump- tion expenditure — to measure inflation, which puts a higher weight on medical costs and a lower weight on shelter prices than the CPI. Fed Chair Yellen, for example, referred to the May inflation data (2.1% headline, 2.0% core) as “noise.” Of course, this overlooks the fact that the May rise in core prices was the largest in a decade and double the 10-year average. If one takes the past 120 inflation observations, the chance of seeing a May-type increase would be 5%. Figure 1. Fixed-income asset class performance 0% 1% 2% 3% 4% 5% 6% 2Q 141Q 14 Japan gov’t Eurozone gov’t U.K. gov’t Emerging- market debt Global high yield U.S. investment- grade corporate debt U.S. floating- rate bankloans Commercial mortgage- backed securities Agency mortgage- backed securities Tax- exempt high yield U.S. tax exempt U.S. government Source: Putnam research, as of 6/30/14. Past performance is not indicative of future results. See page 10 for index definitions. Fixed income delivered strong performance across most sectors in the second quarter of 2014.
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  PUTNAM INVESTMENTS | putnam.com 3 In Europe,the pattern of real growth is largely flat, despite standout strength in Spain and Germany and renewed weakness in France. The same goes for inflation. We think inflation in the United Kingdom and the euro- zone will bottom during the summer. Potential upward pressure from energy and food prices is something to monitor later in the year. Having said that, the disinfla- tionary threat that prompted the ECB’s policy easing decisions is not likely to go away, in our view, given the region’s nontrivial economic weakness. Rate expectations Though we expect U.S. rates to move higher through the year, the ECB’s recent policy moves, including the estab- lishment of a negative deposit rate and the introduction of targeted long-term refinancing operations (TLTROs), may affect that trajectory. Figure 2. Short-term rates remained anchored by the Fed’s monetary policy 0% 1% 2% 3% 4% 6/30/14 3/31/14 30 years 20 years 10 years 7 years 5 years 3 years 1 year 1m onth Source: U.S. Department of the Treasury, as of 6/30/14. Interest rates fell across the intermediate and long portions of a flattening yield curve in the second quarter.
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  4 Q3 2014 | Fixed-Income Outlook Many investorsare looking at the U.S. rate spread rela- tive to Germany as a constraint on U.S. yields moving higher. Over the past decade or so, U.S. rates have generally not traded more than 125 basis points over German rates, which is approximately where the spread is today. Given that the European Central Bank is unlikely to stop providing liquidity very soon, that may keep a lid on European rates and, some market participants feel, consequently slow the ability of U.S. rates to move higher. Outlook for continued support of risk assets We believe the economic backdrop in the quarters ahead will be supportive of riskier fixed-income assets. That said, there are global risk factors we are watching, including recent developments in Iraq and the effect this could have on oil prices. Additionally, we continue to monitor the situation in Ukraine as well as economic tran- sitions under way in China. Volatility has been relatively low among most financial assets, and spread markets have generally continued to tighten toward pre-crisis levels. In our view, that suggests the markets may be more vulnerable to shocks and surprises. In terms of portfolio positioning, we plan to continue emphasizing sectors that have benefited from increased liquidity, such as commercial mortgage-backed securities (CMBS) and non-agency residential mortgage-backed securities (RMBS). However, the yield advantage over Treasuries offered by these sectors is not as great as it was, and with certain central banks potentially raising rates in the medium term, the liquidity in these areas of the market could diminish. Figure 3. High-yield spreads and defaults generally move in tandem over credit cycles 0 4 8 12 16 20% 0 400 800 1200 1600 2000 ’11 ’12 ’13 6/30/14’10’09’08’07’06’05’04’03’02’01’00’99’98’97’96’95’94’93’92’91’90’89’88’87 Defaultrate Spreads(bps) 1990–91 recession 2001 recession 2007–09 recession Current spread: 420 bps (as of 6/30/14) 20-year median spread: 523 bps Average default rate: 3.9% Today, the gap between spreads and defaults remains wide, signaling opportunity for investors. High-yield default rate Spread to worst 1Current default rate includes distressed exchanges. Sources: JPMorgan, High Yield Market Monitor, as of 6/30/14; Putnam Investments. Spreads have come in from all-time highs; defaults remain low. High-yield default rate*
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  PUTNAM INVESTMENTS | putnam.com 5 U.S. high-yieldand bank loans are still fundamentally sound At this stage in the credit cycle, corporate fundamentals continue to appear positive to us. It is noteworthy that distressed Texas electric utility TXU Energy, a sizable issuer in both the high-yield and bank-loan markets, declared bankruptcy during the quarter, but the event was anticipated and did not disrupt either market. Corporations have taken a conservative approach toward managing their assets and liabilities. Many have refinanced debt, have lowered their overall borrowing costs, and are holding substantial cash balances. This conservatism is evident in many of the more recent merger-and-acquisition transactions, where deals were completed using a significant amount of equity, rather than mostly debt. High-yield credit spreads — the yield advantage offered over Treasuries — compressed modestly during the quarter. By the end of June, spreads were below the historical average level but still above the all-time low. However, we continue to view high-yield spreads as attractive on a loss-adjusted basis, although yields and prices somewhat less so. Absent an external shock to the system, we believe the high-yield asset class should continue generating coupon-like returns in the months ahead. Figure 4. Current spreads relative to historical norms n Average excess yield over Treasuries (OAS, 1/1/98–12/31/07) n Current excess yield over Treasuries (OAS as of 6/30/14) Sources: Barclays, Bloomberg, Putnam, as of 6/30/14. Data is provided for informational use only. Past performance is no guarantee of future results. All spreads are in basis points and measure option- adjusted yield spread relative to comparable maturity U.S. Treasuries with the exception of non-agency RMBS and mezzanine CMBS, which are loss-adjusted spreads to swaps calculated using Putnam’s projected assumptions on defaults and severities, and agency IO, which is calculated using assumptions derived from Putnam’s proprietary prepayment model. Agencies are represented by the Barclays U.S. Agency Index. Agency MBS are represented by the Barclays U.S. Mortgage Backed Securities Index. Investment-grade corporates are represented by the Barclays U.S. Corporate Index. High yield is represented by the JPMorgan Developed High Yield Index. AAA CMBS is represented by the Aaa portion of Barclays Investment Grade CMBS Index; mezzanine CMBS is represented by the same index using the AA, A and BBB components. Average OAS for Mezzanine CMBS is for the 2000–2007 time period. Emerging-market debt is represented by the Barclays EM Hard Currency Aggregate Index. Non-agency RMBS is estimated using average market level of a sample of below-investment-grade securities backed by various types of non-agency mortgage collateral (excluding prime securities). Mezzanine CMBS is estimated from an average spread among baskets of Putnam-monitored new issue and seasoned mezzanine securities, as well as a synthetic (CMBX) index. Agency IO is estimated from a basket of Putnam-monitored interest-only (IO) and inverse IO securities. Option-adjusted spread (OAS) measures the yield over duration equivalent Treasuries for securities with different embedded options. 56 130 89 123 123  150  129 425 34 35 24 0 200 400 600 800 1000 685 350 100 130 260 500 115 339 104 99 573 Non-agency  RMBS CMBS – Mezzanine Emerging- market debt Agency IOHigh yieldAAA CMBS Investment-grade corporates Agency MBS Agencies 56 130 89 123 123  150  129 425 34 35 24 0 200 400 600 800 1000 685 350 100 130 260 500 115 339 104 99 573 Non-agency  RMBS CMBS – Mezzanine Emerging- market debt Agency IOHigh yieldAAA CMBS Investment-grade corporates Agency MBS Agencies We continue to find compelling investment opportunities in out-of-benchmark sectors, given their relative spread levels and solid underlying fundamentals.
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  6 Q3 2014 | Fixed-Income Outlook As forportfolio positioning, we generally increased high-yield portfolio allocations to Ba-rated bonds while reducing exposures to Caa-rated securities. In addi- tion, given the recent underperformance of bank loans compared with high-yield bonds, we felt loan valuations had become more attractive, so we increased loan hold- ings in May and June. Securitized markets continue to attract investors In the second quarter, our mortgage-related credit strategies performed well, particularly our exposures to commercial mortgage-backed securities [CMBS] and non-agency residential mortgage-backed securities [RMBS]. These sectors were aided by investor demand for higher-yielding securities, supportive fundamentals, and the prospect of increased global liquidity in light of the ECB’s policy announcement. Figure 5. Excess returns relative to U.S. Treasuries 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% MBSCMBSU.S. investment- grade credit Emerging-markets debt (EMD) High yield Source: Barclays, as of 6/30/14. Past performance is not indicative of future results. In the context of a 2.66% return for 10-year U.S. Treasuries, most other sectors outperformed, with high yield and EMD exhibiting particularly strong performance.
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  PUTNAM INVESTMENTS | putnam.com 7 Within CMBS,portfolios generally benefited from solid security selection in subordinated “mezzanine” bonds rated BBB/Baa, which offered higher yields at what we believe are acceptable risks. Within non-agency RMBS, pay-option adjustable-rate mortgage-backed securities were the main contributors. Our prepayment strategies, which we implemented with securities such as interest-only and inverse interest- only collateralized mortgage obligations [CMOs], provided a further boost to relative performance. Although rates fell during the quarter, the decline wasn’t great enough to trigger increased refinancing of the mortgages underlying our CMO holdings. As a result, continued slow prepayment speeds bolstered the securi- ties’ values. Emerging markets: Latin American favorites In emerging Asian economies, we found debt markets to be priced fairly, which means they represented relatively little upside potential. Consequently, we de-emphasized exposures to this region. In Eastern Europe, the Middle East, and Africa, we believed geopolitical tensions were likely to remain high, so we were selective in our approach to debt markets in this broad region, which also helped our EM portfolios. Notably, despite soaring volatility in Russian and Ukrai- nian asset markets, these areas performed better as the period wore on. Ukrainian debt became a top performer relative to other EMD in May as tensions between Ukraine and Russia — and the spillover anxiety these tensions caused for a variety of other markets — eased somewhat on a global stage. We found the best relative risk-reward potential was in Latin American debt markets. Importantly, Latin Amer- ican credit fundamentals did not deteriorate through the period and thus continued to support government bonds in this region. Credit spreads were not nearly as wide in Latin America as in some of the riskier emerging markets, such as Ukraine, nor were they as tight as in some Asian markets, which contributed to the upside potential we perceived in Latin American government debt. Argentine debt encountered difficulties starting in May as the approach of a key date in the multi-year legal battle between Argentina and holdout creditors — investors who refused to accept a restructured, and less valuable, form of the country’s debt in the wake of the country’s prior default — made many investors nervous. Nevertheless, we think the country represents a posi- tive long-term value to investors and that the yields are attractive given the country’s fundamentals. Problems with creditors pose a major political hurdle, but we believe the country’s significant agricultural assets and recent discoveries of natural resources put Argentina in a better position economically to weather a difficult cycle for its debt. Municipal bonds post favorable results Fundamental and technical (supply/demand) factors contributed to a very hospitable environment for municipal bonds during the second quarter. Falling rates, lower-trending volatility in both equity and bond markets, ECB easing, and the U.S. Fed’s affirmation of its commit- ment to low rates all converged as helpful factors. By the end of the quarter, the yield on the benchmark 10-year Treasury note had fallen from 2.72% to 2.53%, and prices rose commensurately. Municipal bonds followed a similar path as Treasuries during the rally but had other tailwinds propelling their prices higher. Municipal bond issuance, which has been trending down in recent years, continued at a modest pace, and this was beneficial for prices. The declining volume of new long-term municipal bonds coming to market is due, in part, to state and local governments undertaking fewer projects while turning their fiscal attention toward funding employee pensions and other fixed costs in their budgets. This modest level of supply has not kept pace with the solid demand from traditional tax-sensitive retail investors. Crossover taxable buyers have also been drawn to the competitive yields and attractive relative value offered by this asset class rather than its tax benefit.
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  8 Q3 2014 | Fixed-Income Outlook Figure 6:Muni credit spreads have narrowed from historical wides, but remain attractive Municipal bond spreads by quality rating AA A BBB 0 100 200 300 400 500 6/30/14201320122011201020092008200720062005200420032002200120001999 Source: Putnam, as of 6/30/14. Credit ratings are as determined by Putnam. The most attractive relative values continue to populate in the BBB-rated segment of the muni market. Meanwhile, inflows to tax-free mutual funds, an impor- tant measure of demand, remained positive during the second quarter of 2014 — primarily in tax-free high-yield bond funds. Thus, with interest rates still low and funda- mental credit quality improving, there has been greater investor appetite for the yields offered by the relatively riskier municipal bonds further out on the maturity spectrum as well as for those in the lower-rated, higher- yielding sectors. Despite the strong start for municipal bonds in 2014 and our belief that the credit outlook for municipal bonds appears solid given improvement in U.S. growth, we still remain cautious and believe that there could be some volatility surrounding supply/demand factors and interest rates in the coming months. With regard to tax policy, we think comprehensive tax reform is unlikely at least until after the 2014 mid-term elections.
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  PUTNAM INVESTMENTS | putnam.com 9 Currency outlook Withinactive currency strategies, we now favor a small overweight position in the U.S. dollar. The outcome of the June FOMC meeting was largely as expected: The taper continued, the post-meeting statement was little changed, the 2015 and 2016 interest-rate forecasts were revised somewhat higher and the longer-term forecast somewhat lower, and Yellen’s press conference continued to indicate no urgency to step back from highly accom- modative monetary policy. As a result, future monetary policy remains very much data dependent. If growth and inflation rebound soundly, as we expect, the Fed’s view is likely to be challenged and rate hikes will begin to get priced in sooner, which should be supportive of the U.S. dollar over the course of the year. The euro position remains an underweight. Over the past month, the ECB agreed to cut its deposit rate below zero, provide new four-year long-term refinancing operation loans in September and December, stop sterilizing its Securities Markets Program bond purchases, and work on options for buying private-sector asset-backed securities in future. All of these measures appear sufficient to cap the single currency in its current 1.35–1.40 range against the dollar, and the anticipated developments in the U.S. story should help to push this value down over the coming months. The British pound sterling positioning remains a modest overweight. Bank of England Governor Mark Carney signaled in a June speech that interest rates may need to rise earlier than markets were anticipating. He subsequently highlighted that the economy continues to have more slack to absorb before interest rates need to rise. Also, while the pace of job creation has been strong, wage growth had been softer than expected. This some- what puzzling outlook should be viewed as preparing the market for earlier tightening but at a more gradual pace, and eventually arriving at a lower terminal rate than past tightening cycles. A quite modest underweight position to the Japanese yen remains after an extended period of being neutral. We expect that the Bank of Japan will have to do more, which should provide further impetus for the U.S. dollar to move higher versus the yen. However, Bank of Japan Governor Haruhiko Kuroda remains optimistic around the recovery in the economy and the trajectory of recent inflation data. He remains clear that if growth is weaker than expected and inflation does not accelerate, then the BoJ will do more.
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  10 Q3 2014 | Fixed-Income Outlook Agencymortgage-backedsecurities arerepresented by the Barclays U.S. Mortgage Backed Securities Index, which covers agency mortgage-backed pass-through securities (both fixed-rate and hybrid ARM) issued by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). Commercialmortgage-backedsecurities are represented by the Barclays U.S. CMBS Investment Grade Index, which measures the market of commercial mortgage- backed securities with a minimum deal size of $500 million. The two subcomponents of the U.S. CMBS Investment Grade Index are U.S. aggregate-eligible securities and non-eligible securities. To be included in the U.S. Aggregate Index, the securities must meet the guidelines for ERISA eligibility. Emerging-marketdebt is represented by the JPMorgan Emerging Markets Global Diversified Index, which is composed of U.S. dollar-denominated Brady bonds, eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities. Eurozonegovernment is represented by the Barclays European Aggregate Bond Index, which tracks fixed-rate, investment-grade securities issued in the following European currencies: euro, Norwegian krone, Danish krone, Swedish krona, Czech koruna, Hungarian forint, Polish zloty, and Swiss franc. Globalhighyield is represented by the BofA Merrill Lynch Global High Yield Constrained Index, an unmanaged index of global high-yield fixed-income securities. Japangovernment is represented by the Barclays Japanese Aggregate Bond Index, a broad-based investment-grade benchmark consisting of fixed-rate Japanese yen-denominated securities. Tax-exempthighyieldisrepresentedbytheBarclaysMunicipalBondHighYieldIndex, which consists of below-investment-grade or unrated bonds with outstanding par valuesofatleast$3millionandatleastoneyearremaininguntiltheirmaturitydates. U.K.government is represented by the Barclays Sterling Aggregate Bond Index, which contains fixed-rate, investment-grade, sterling-denominated securities, including gilt and non-gilt bonds. U.S.floating-ratebankloans are represented by the SP/LSTA Leveraged Loan Index, an unmanaged index of U.S. leveraged loans. U.S.governmentandagencydebt is represented by the Barclays U.S. Aggregate Bond Index, an unmanaged index of U.S. investment-grade fixed-income securities. U.S.investment-gradecorporatedebt is represented by the Barclays U.S. Corporate Index, a broad-based benchmark that measures the U.S. taxable investment-grade corporate bond market. U.S.taxexempt is represented by the Barclays Municipal Bond Index, an unmanaged index of long-term fixed-rate investment-grade tax-exempt bonds. You cannot invest directly in an index. This material is provided for limited purposes. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Putnam product or strategy. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. The views and strategies described herein may not be suitable for all investors. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the article. Predictions, opinions, and other information contained in this article are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss. The information provided relates to Putnam Investments and its affiliates, which include The Putnam Advisory Company, LLC and Putnam Investments Limited®. Prepared for use in Canada by Putnam Investments Inc. [Investissements Putnam Inc.] (o/a Putnam Management in Manitoba). Where permitted, advisory services are provided in Canada by Putnam Investments Inc. [Investissements Putnam Inc.] (o/a Putnam Management in Manitoba) and its affiliate, The Putnam Advisory Company, LLC.
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  PUTNAM INVESTMENTS | putnam.com 11 Putnam’s veteranfixed-income team offers a depth and breadth of insight and an independent view of risk. Successful investing in today’s markets requires a broad-based approach, the flexibility to exploit a range of sectors and investment opportunities, and a keen understanding of the complex global interrelationships that drive the markets. That is why Putnam has more than 70 fixed- income professionals focusing on delivering comprehensive coverage of every aspect of the fixed-income markets, based not only on sector, but also on the broad sources of risk — and opportunities — most likely to drive returns. D. William Kohli Co-Head of Fixed Income Global Strategies Investing since 1987 Joined Putnam in 1994 Michael V. Salm Co-Head of Fixed Income Liquid Markets and Securitized Products Investing since 1989 Joined Putnam in 1997 Paul D. Scanlon, CFA Co-Head of Fixed Income Global Credit Investing since 1986 Joined Putnam in 1999
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  Consider these risksbefore investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Derivatives also involve the risk, in the case of many over-the-counter instruments, of the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations. Bond investments are subject to interest-rate risk, which means the prices of the funds’ bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. You can lose money by investing in a mutual fund. If you are a U.S. retail investor, please request a prospectus, or a summary prospectus if available, from your financial representative or by calling Putnam at 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. In the United States, mutual funds are distributed by Putnam Retail Management. PUTNAM INVESTMENTS | putnam.com CM0200 289088 7/14 Market update putnam.com/markets Research putnam.com/perspectives putnam.com/white-papers Find us