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Putnam Fixed Income Outlook q313

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Putnam’s outlook
Arrows in 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: Dollar
The end of QE coming into focus
In the second quarter of 2013, the debate
over the end of quantitative easing (QE)
became the focus of markets globally, which
culminated in June with a statement by Fed
Chairman Ben Bernanke on the economically
driven prospects for curtailing the Fed’s bond-
buying programs. This marked what may
prove to be a critical inflection point for the
Federal Reserve, the U.S. economy, and global
securities markets.
Since the financial crisis of 2008, the Fed
has been firmly committed to keeping interest
rates low for an extended period of time,
providing liquidity to bond markets. But with
the recent talk of QE tapering, the markets
are faced with a potential liquidity drain as the
Fed may soon claim success and back away
from its QE program. The market’s reaction
to this potential change was anything but
calm. Across most fixed-income markets,
bond yields rose, spreads to Treasuries
widened, and bond prices fell. The yield on the
10-year Treasury note, for example, backed
up in dramatic fashion, moving from an
intra-quarter low of 1.63% on May 2 to 2.67%
following Chairman Bernanke’s remarks. As
a result of this new phase in the recovery
dialogue, we believe markets will continue
to see higher volatility in rates, although the
range we expect in the near term for 10-year
Treasuries — between 2.25% and 2.75% — is
not high by historical standards.
Volatility has generally been elevated
since May, and has cut across fixed-income
and equity sectors alike. The questions that
are raised by increased volatility as a result
of merely discussing the pullback in QE are
Key takeaways
•	We expect the U.S. economy to improve, which could tilt the
Fed toward curtailing bond purchases in the fall.
•	We expect interest rates will stay elevated — in a range of
2.25% to 2.75% for 10-year Treasuries — and volatile.
•	Spread sectors look attractive to us going forward, although
security selection will likely add more value than broad
sector bets.
•	Interest-rate volatility may provide opportunities for tactical
duration positioning and prepayment strategies.
Fixed-Income Outlook
Q3 2013 » Putnam Perspectives
2
Q3 2013 | Fixed-Income Outlook
difficult to answer: Can the United States stay on the path
of economic recovery and normalization in an environ-
ment of higher rates? And what do fixed-income markets
look like if government-provided liquidity support is no
longer part of the equation? As the Fed continues to
publicly consider its exit plan from QE, we see markets
grappling with these questions in the months ahead —
particularly as the Fed nears its mid-September meeting
for reopening the end-of-QE debate.
Our outlook for continued economic recovery
Despite higher taxes, generally rising interest rates,
and broad-based budget cuts enforced by the federal
sequester, the U.S. recovery appeared to remain on
track through the second quarter, and we see the United
States maintaining this course in the months ahead.
From housing market gains and declining unemployment
figures to encouraging manufacturing data and corpo-
rate fundamentals, the balance of data was pleasantly
surprising through the end of the second quarter of 2013.
This was a welcome change over recent years, where
the end of the second quarter saw the onset of a summer
slowdown. While the economy initially appeared to be
in the process of repeating this pattern in 2013, data
improved toward quarter-end. And while this may
have contributed to the Fed’s willingness to discuss its
processes for evaluating and implementing an end to
QE, we think it bodes well for select areas of the fixed-
income markets.
Importantly, we expect that the benchmark Barclays
U.S. Aggregate Bond Index will continue to be a poor
representative of value in the domestic fixed-income
marketplace. At an average duration of approximately five
years, the index, and strategies that are aligned closely
to it, may be overexposed to interest-rate risk. Given the
climate of rising rates — and the degree to which rates
have shown their ability to back up on fears of the eventual
QE withdrawal — we believe term structure risk, which
dominates the Aggregate Index, is best avoided in favor of
sectors with more attractive risk-and-return profiles.
Figure 1: The second quarter erased
first-quarter gains
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
2Q 131Q 13
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 6/30/13. Past performance is not indicative of future results. See page 10 for index definitions.
Fixed-income assets suffered
as interest rates rose and bond
prices fell.
PUTNAM INVESTMENTS | putnam.com
3
Mortgage-related debt: potential gains from
tailwinds in the housing recovery
If the economy makes advances as we think it will, the U.S.
housing market should continue to grow stronger and
opportunities in mortgage-related debt markets should
continue to exhibit attractive characteristics. We do not
see higher rates derailing or detracting significantly from
the housing recovery. In our view, the housing market
advance has not been a function of low mortgage rates,
but rather has been driven by overall economic activity and
confidence levels. With an economic recovery underway,
nominally higher interest rates may simply be trumped by
improving housing market fundamentals, new household
formation trends, and growing consumer strength.
Our perspective on mortgage-related opportunities,
regardless of the prevailing economic conditions, centers
on two major forms of risk. The first of these is prepay-
ment risk. In light of the prevailing policy uncertainty
and the historically low rate environment at the start of
the second quarter, we cut back on prepayment risk by
reducing our holdings of collateralized mortgage obliga-
tions (CMOs). Following significant underperformance and
spread widening in April and May, we sought to capitalize
on CMOs’ improved relative value by adding them back to
a number of our portfolios. With the increase in interest
rates, CMOs rallied as prepayments slowed within the
pool of underlying mortgages. As the tug of war between
housing strength and higher rates plays out, we expect to
continue to operate tactically in this space, taking advan-
tage of market volatility as much as possible.
The second area of mortgage-related risk is credit
risk. Our mortgage credit holdings — both non-agency
residential mortgage-backed securities (RMBS) and
commercial mortgage-backed securities (CMBS) —
had mixed results in the second quarter. RMBS had an
up-and-down quarter. Through mid-May, the sector had
outperformed duration-adjusted Treasuries at a faster
pace than in the first quarter. Average spreads for the
sector tightened by approximately 50 basis points (bps)
during this period, driven by a continued positive tech-
nical environment as investors regained their appetite
for higher-yielding securities and the declining size of the
market supported prices. Fundamentals also supported
the market with positive home-price data, reduced delin-
quency trends, and continued activity from buy-to-rent
investors. The latter part of the quarter exhibited signifi-
cant underperformance due primarily to technical factors.
Average spreads for the sector over the entire quarter
widened by approximately 100 bps.
Despite underperformance for the overall sector, our
holdings in commercial mortgage-backed securities
(CMBS) aided performance, especially earlier in the period
as investors took advantage of attractive spreads and
positive underlying fundamentals in the sector.
We sought to reduce risk during the quarter by shifting
allocations from RMBS into better-performing CMBS. As
with our prepayment strategies, toward the quarter’s end
we began to add mortgage credit risk back into our port-
folios in light of recent spread widening, and will continue
to seek to make volatility work to our advantage.
Given the climate of rising rates — and the degree to which rates have shown
their ability to back up on fears of the eventual QE withdrawal — we believe
term structure risk is best avoided in favor of sectors with more attractive
risk-and-return profiles.
4
Q3 2013 | Fixed-Income Outlook
High yield and bank loans: low default
expectations and capital appreciation potential
With respect to opportunities in high-yield bonds, the
biggest change in the second quarter centered on market
technicals. Outflows from some large mutual funds and
exchange-traded funds (ETFs), in addition to some large
allocation changes by institutional investors, upset the
balance of high-yield supply and demand, leading to a
fairly disruptive environment for the sector. Along with
other credit-sensitive fixed-income categories, high-yield
bond results struggled during May and June, and our
general allocation to the asset class detracted from port-
folio performance.
The flip side of this heightened illiquidity is that the
prices of many high-yield bonds declined to what we
believe are attractive levels. When we consider the
general cohort of high-yield issuing companies, we see a
strong fundamental backdrop and expect that defaults
will hover near historically low levels.
Although we take a more skeptical view of cyclical
sectors, such as natural resources — particularly coal
and metals and mining companies — we are more posi-
tive on retail, cable, and wireless industries, where we
see the potential for continued consolidation. Merger
and acquisition activity, which has room to grow in an
improving macro environment, is largely beneficial for
high-yield issuers. With economic tailwinds, and following
an extended period of cost-cutting, many larger compa-
nies want to buy smaller companies in order to gain scale,
and add new capabilities or enhance existing ones. And
with high-yield bond prices lower relative to more recent
premium levels, the potential for capital appreciation
cannot be overlooked.
Figure 2. Rates leapt higher as the Fed
discussed winding down its
bond-buying programs
0%
1%
2%
3%
3/31/13
6/30/13
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 6/30/13.
Policy uncertainty could keep rate
volatility elevated in the months ahead.
PUTNAM INVESTMENTS | putnam.com
5
Figure 3. 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 6/30/13)
Year to date, one of the stronger-performing credit
subsectors has been bank loans. Bank loans have been
available at attractive spreads over prevailing short-term
rates, and as short-term interest rates start to increase,
bank loan coupons are structured to reset higher. In addi-
tion, the sector has benefited from prevailing fundamental
strength among loan issuers, and particularly in light of
the fact that many issuers have refinanced other obliga-
tions that they accumulated between 2007 and 2009.
Like high-yield debt, bank loans may stand to benefit
from an improving macro environment in which MA
activity is on the rise. Funding acquisitions with bank loans
is an attractive option for many companies, as interest
rates on these loans tend to be lower and because the
loans are generally free of restrictions on prepayment at
par value. As we expect the broad market to continue to
focus on the potential magnitude of rates’ upward trajec-
tory, and as we expect a supportive economic backdrop to
fuel MA activity, bank loans may be relatively well posi-
tioned to outperform.
Sources: Barclays, Putnam, as of 6/30/13.
Data are 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, 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 Barclays U.S. Agency Index. Agency MBS are represented by Barclays
U.S. Mortgage Backed Securities Index. Investment-grade corporates are represented by Barclays U.S. Corporate Index. High yield is represented by
Barclays U.S. Corporate High Yield Index. AAA CMBS are represented by the Aaa portion of Barclays Investment Grade CMBS Index. EMD is repre-
sented by Barclays Global Emerging Markets Index. Non-agency is estimated using average market level of a sample of below-investment-grade
securities backed by Alt-A collateral. Agency IO is estimated from a basket of Putnam-monitored interest-only securities. Option-adjusted spread
(OAS) measures the yield spread over duration equivalent Treasuries for securities with different embedded options.
56
130
89
573
123
150 
425
34 38
61
0
200
400
600
800
1000
725
800
300
200
345
538
130
152
EMDAgency IONon-agency
 RMBS
High yieldAAA CMBSInvestment-grade
corporates
Agency
MBS
Agencies
56
130
89
573
123
150 
425
34 38
61
0
200
400
600
800
1000
725
800
300
200
345
538
130
152
EMDAgency IONon-agency
 RMBS
High yieldAAA CMBSInvestment-grade
corporates
Agency
MBS
Agencies
Spreads widened but in
many cases remained
close to their historical
averages.
6
Q3 2013 | Fixed-Income Outlook
Investment-grade credit: sector-based pockets
of relative strength
Like most other sectors in the recent quarter, longer-
dated, investment-grade markets were shaken by rate
jitters and the knock-on performance effects of invest-
ment outflows. Overall, we are finding better relative value
opportunities in the short to medium range of the yield
curve, as longer-dated credits may be overexposed to
interest-rate risk.
In terms of sectors, we continue to see banking as one
of the bright spots for investment-grade corporate credit.
The passage of industry regulation, including higher
capital requirements, has essentially transformed this still-
recovering sector. What was once a high-growth industry
with attractive returns from an equity perspective is now
a source of low and stable growth, which from an income
investor’s perspective is highly desirable.
Other sectors that we like going forward include utili-
ties and economically sensitive industries. Like banking,
the utilities sector is increasingly regulated, which confers
a level of perceived stability that recommends the sector
to income investors. On the economically sensitive front,
the U.S. shale-gas boom has lowered input costs of fuel
production and hence has given the entire petrochemical
industry an enormous boost, including downstream
industries focused on fertilizers and chemicals. Profit
margins in these areas are as wide as they’ve been for
some time, and we believe this condition is likely to persist.
Sectors with less compelling prospects include phar-
maceuticals and defense, which are trading very tight
to Treasuries, and where we don’t foresee a great deal
of improvement in the near future. Consequently, these
sectors form some of the largest underweights in our
investment-grade credit portfolios.
Figure 4. Spread sectors’ negative excess
returns relative to Treasuries
-0.6%
-0.5%
-0.4%
-0.3%
-0.2%
-0.1%
0.0%
U.S. agency
MBS
Corporates
CMBS
ABS
Source: Barclays, as of 6/30/13. Past performance is not indicative of future results.
Bond returns suffered broadly as
markets reacted poorly to a potential
change in Fed policy.
To the extent that interest rates rise on the long end of the yield curve and people
believe in the sustainability of U.S. economic strength, a variety of U.S. assets
become more attractive.

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Putnam Fixed Income Outlook q313

  • 1. Putnam’s outlook Arrows in 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: Dollar The end of QE coming into focus In the second quarter of 2013, the debate over the end of quantitative easing (QE) became the focus of markets globally, which culminated in June with a statement by Fed Chairman Ben Bernanke on the economically driven prospects for curtailing the Fed’s bond- buying programs. This marked what may prove to be a critical inflection point for the Federal Reserve, the U.S. economy, and global securities markets. Since the financial crisis of 2008, the Fed has been firmly committed to keeping interest rates low for an extended period of time, providing liquidity to bond markets. But with the recent talk of QE tapering, the markets are faced with a potential liquidity drain as the Fed may soon claim success and back away from its QE program. The market’s reaction to this potential change was anything but calm. Across most fixed-income markets, bond yields rose, spreads to Treasuries widened, and bond prices fell. The yield on the 10-year Treasury note, for example, backed up in dramatic fashion, moving from an intra-quarter low of 1.63% on May 2 to 2.67% following Chairman Bernanke’s remarks. As a result of this new phase in the recovery dialogue, we believe markets will continue to see higher volatility in rates, although the range we expect in the near term for 10-year Treasuries — between 2.25% and 2.75% — is not high by historical standards. Volatility has generally been elevated since May, and has cut across fixed-income and equity sectors alike. The questions that are raised by increased volatility as a result of merely discussing the pullback in QE are Key takeaways • We expect the U.S. economy to improve, which could tilt the Fed toward curtailing bond purchases in the fall. • We expect interest rates will stay elevated — in a range of 2.25% to 2.75% for 10-year Treasuries — and volatile. • Spread sectors look attractive to us going forward, although security selection will likely add more value than broad sector bets. • Interest-rate volatility may provide opportunities for tactical duration positioning and prepayment strategies. Fixed-Income Outlook Q3 2013 » Putnam Perspectives
  • 2. 2 Q3 2013 | Fixed-Income Outlook difficult to answer: Can the United States stay on the path of economic recovery and normalization in an environ- ment of higher rates? And what do fixed-income markets look like if government-provided liquidity support is no longer part of the equation? As the Fed continues to publicly consider its exit plan from QE, we see markets grappling with these questions in the months ahead — particularly as the Fed nears its mid-September meeting for reopening the end-of-QE debate. Our outlook for continued economic recovery Despite higher taxes, generally rising interest rates, and broad-based budget cuts enforced by the federal sequester, the U.S. recovery appeared to remain on track through the second quarter, and we see the United States maintaining this course in the months ahead. From housing market gains and declining unemployment figures to encouraging manufacturing data and corpo- rate fundamentals, the balance of data was pleasantly surprising through the end of the second quarter of 2013. This was a welcome change over recent years, where the end of the second quarter saw the onset of a summer slowdown. While the economy initially appeared to be in the process of repeating this pattern in 2013, data improved toward quarter-end. And while this may have contributed to the Fed’s willingness to discuss its processes for evaluating and implementing an end to QE, we think it bodes well for select areas of the fixed- income markets. Importantly, we expect that the benchmark Barclays U.S. Aggregate Bond Index will continue to be a poor representative of value in the domestic fixed-income marketplace. At an average duration of approximately five years, the index, and strategies that are aligned closely to it, may be overexposed to interest-rate risk. Given the climate of rising rates — and the degree to which rates have shown their ability to back up on fears of the eventual QE withdrawal — we believe term structure risk, which dominates the Aggregate Index, is best avoided in favor of sectors with more attractive risk-and-return profiles. Figure 1: The second quarter erased first-quarter gains -6% -5% -4% -3% -2% -1% 0% 1% 2% 3% 2Q 131Q 13 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 6/30/13. Past performance is not indicative of future results. See page 10 for index definitions. Fixed-income assets suffered as interest rates rose and bond prices fell.
  • 3. PUTNAM INVESTMENTS | putnam.com 3 Mortgage-related debt: potential gains from tailwinds in the housing recovery If the economy makes advances as we think it will, the U.S. housing market should continue to grow stronger and opportunities in mortgage-related debt markets should continue to exhibit attractive characteristics. We do not see higher rates derailing or detracting significantly from the housing recovery. In our view, the housing market advance has not been a function of low mortgage rates, but rather has been driven by overall economic activity and confidence levels. With an economic recovery underway, nominally higher interest rates may simply be trumped by improving housing market fundamentals, new household formation trends, and growing consumer strength. Our perspective on mortgage-related opportunities, regardless of the prevailing economic conditions, centers on two major forms of risk. The first of these is prepay- ment risk. In light of the prevailing policy uncertainty and the historically low rate environment at the start of the second quarter, we cut back on prepayment risk by reducing our holdings of collateralized mortgage obliga- tions (CMOs). Following significant underperformance and spread widening in April and May, we sought to capitalize on CMOs’ improved relative value by adding them back to a number of our portfolios. With the increase in interest rates, CMOs rallied as prepayments slowed within the pool of underlying mortgages. As the tug of war between housing strength and higher rates plays out, we expect to continue to operate tactically in this space, taking advan- tage of market volatility as much as possible. The second area of mortgage-related risk is credit risk. Our mortgage credit holdings — both non-agency residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) — had mixed results in the second quarter. RMBS had an up-and-down quarter. Through mid-May, the sector had outperformed duration-adjusted Treasuries at a faster pace than in the first quarter. Average spreads for the sector tightened by approximately 50 basis points (bps) during this period, driven by a continued positive tech- nical environment as investors regained their appetite for higher-yielding securities and the declining size of the market supported prices. Fundamentals also supported the market with positive home-price data, reduced delin- quency trends, and continued activity from buy-to-rent investors. The latter part of the quarter exhibited signifi- cant underperformance due primarily to technical factors. Average spreads for the sector over the entire quarter widened by approximately 100 bps. Despite underperformance for the overall sector, our holdings in commercial mortgage-backed securities (CMBS) aided performance, especially earlier in the period as investors took advantage of attractive spreads and positive underlying fundamentals in the sector. We sought to reduce risk during the quarter by shifting allocations from RMBS into better-performing CMBS. As with our prepayment strategies, toward the quarter’s end we began to add mortgage credit risk back into our port- folios in light of recent spread widening, and will continue to seek to make volatility work to our advantage. Given the climate of rising rates — and the degree to which rates have shown their ability to back up on fears of the eventual QE withdrawal — we believe term structure risk is best avoided in favor of sectors with more attractive risk-and-return profiles.
  • 4. 4 Q3 2013 | Fixed-Income Outlook High yield and bank loans: low default expectations and capital appreciation potential With respect to opportunities in high-yield bonds, the biggest change in the second quarter centered on market technicals. Outflows from some large mutual funds and exchange-traded funds (ETFs), in addition to some large allocation changes by institutional investors, upset the balance of high-yield supply and demand, leading to a fairly disruptive environment for the sector. Along with other credit-sensitive fixed-income categories, high-yield bond results struggled during May and June, and our general allocation to the asset class detracted from port- folio performance. The flip side of this heightened illiquidity is that the prices of many high-yield bonds declined to what we believe are attractive levels. When we consider the general cohort of high-yield issuing companies, we see a strong fundamental backdrop and expect that defaults will hover near historically low levels. Although we take a more skeptical view of cyclical sectors, such as natural resources — particularly coal and metals and mining companies — we are more posi- tive on retail, cable, and wireless industries, where we see the potential for continued consolidation. Merger and acquisition activity, which has room to grow in an improving macro environment, is largely beneficial for high-yield issuers. With economic tailwinds, and following an extended period of cost-cutting, many larger compa- nies want to buy smaller companies in order to gain scale, and add new capabilities or enhance existing ones. And with high-yield bond prices lower relative to more recent premium levels, the potential for capital appreciation cannot be overlooked. Figure 2. Rates leapt higher as the Fed discussed winding down its bond-buying programs 0% 1% 2% 3% 3/31/13 6/30/13 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 6/30/13. Policy uncertainty could keep rate volatility elevated in the months ahead.
  • 5. PUTNAM INVESTMENTS | putnam.com 5 Figure 3. 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 6/30/13) Year to date, one of the stronger-performing credit subsectors has been bank loans. Bank loans have been available at attractive spreads over prevailing short-term rates, and as short-term interest rates start to increase, bank loan coupons are structured to reset higher. In addi- tion, the sector has benefited from prevailing fundamental strength among loan issuers, and particularly in light of the fact that many issuers have refinanced other obliga- tions that they accumulated between 2007 and 2009. Like high-yield debt, bank loans may stand to benefit from an improving macro environment in which MA activity is on the rise. Funding acquisitions with bank loans is an attractive option for many companies, as interest rates on these loans tend to be lower and because the loans are generally free of restrictions on prepayment at par value. As we expect the broad market to continue to focus on the potential magnitude of rates’ upward trajec- tory, and as we expect a supportive economic backdrop to fuel MA activity, bank loans may be relatively well posi- tioned to outperform. Sources: Barclays, Putnam, as of 6/30/13. Data are 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, 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 Barclays U.S. Agency Index. Agency MBS are represented by Barclays U.S. Mortgage Backed Securities Index. Investment-grade corporates are represented by Barclays U.S. Corporate Index. High yield is represented by Barclays U.S. Corporate High Yield Index. AAA CMBS are represented by the Aaa portion of Barclays Investment Grade CMBS Index. EMD is repre- sented by Barclays Global Emerging Markets Index. Non-agency is estimated using average market level of a sample of below-investment-grade securities backed by Alt-A collateral. Agency IO is estimated from a basket of Putnam-monitored interest-only securities. Option-adjusted spread (OAS) measures the yield spread over duration equivalent Treasuries for securities with different embedded options. 56 130 89 573 123 150  425 34 38 61 0 200 400 600 800 1000 725 800 300 200 345 538 130 152 EMDAgency IONon-agency  RMBS High yieldAAA CMBSInvestment-grade corporates Agency MBS Agencies 56 130 89 573 123 150  425 34 38 61 0 200 400 600 800 1000 725 800 300 200 345 538 130 152 EMDAgency IONon-agency  RMBS High yieldAAA CMBSInvestment-grade corporates Agency MBS Agencies Spreads widened but in many cases remained close to their historical averages.
  • 6. 6 Q3 2013 | Fixed-Income Outlook Investment-grade credit: sector-based pockets of relative strength Like most other sectors in the recent quarter, longer- dated, investment-grade markets were shaken by rate jitters and the knock-on performance effects of invest- ment outflows. Overall, we are finding better relative value opportunities in the short to medium range of the yield curve, as longer-dated credits may be overexposed to interest-rate risk. In terms of sectors, we continue to see banking as one of the bright spots for investment-grade corporate credit. The passage of industry regulation, including higher capital requirements, has essentially transformed this still- recovering sector. What was once a high-growth industry with attractive returns from an equity perspective is now a source of low and stable growth, which from an income investor’s perspective is highly desirable. Other sectors that we like going forward include utili- ties and economically sensitive industries. Like banking, the utilities sector is increasingly regulated, which confers a level of perceived stability that recommends the sector to income investors. On the economically sensitive front, the U.S. shale-gas boom has lowered input costs of fuel production and hence has given the entire petrochemical industry an enormous boost, including downstream industries focused on fertilizers and chemicals. Profit margins in these areas are as wide as they’ve been for some time, and we believe this condition is likely to persist. Sectors with less compelling prospects include phar- maceuticals and defense, which are trading very tight to Treasuries, and where we don’t foresee a great deal of improvement in the near future. Consequently, these sectors form some of the largest underweights in our investment-grade credit portfolios. Figure 4. Spread sectors’ negative excess returns relative to Treasuries -0.6% -0.5% -0.4% -0.3% -0.2% -0.1% 0.0% U.S. agency MBS Corporates CMBS ABS Source: Barclays, as of 6/30/13. Past performance is not indicative of future results. Bond returns suffered broadly as markets reacted poorly to a potential change in Fed policy. To the extent that interest rates rise on the long end of the yield curve and people believe in the sustainability of U.S. economic strength, a variety of U.S. assets become more attractive.
  • 7. PUTNAM INVESTMENTS | putnam.com 7 Global bonds: opportunities in the making In Europe, debt-challenged peripheral European coun- tries exhibited unanticipated health through the second quarter, which was largely a function of declining sover- eign borrowing costs. Italy and Spain, for example, appeared able to fund themselves, while core European countries experienced some economic setbacks. More recently, data out of Germany and Switzerland improved, which contributes to our sense of continued recovery in the eurozone. In Japan, policymakers are actively pursuing a QE policy experiment, which has led to substantial volatility in equity markets there. Japanese stocks have appreci- ated at a rapid pace since last November, but in the recent quarter have retraced a good portion of their gains. Simi- larly, the yen very quickly declined substantially relative to other major currencies, but then reversed course for a time before resuming its weakening trend. Despite global competitiveness among certain Japanese exporters, we have yet to see the Japanese economy exhibit a funda- mental shift toward growth in response to policymakers’ QE program, and Japan remains an area that we will monitor closely for investment opportunities. Figure 5. 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 6/30/13’10’09’08’07’06’05’04’03’02’01’00’99’98’97’96’95’94’93’92’91’90’89’88’87 Defaultrate Spreads(bps) 1990–91 recession 2001 recession 2007–09 recession Current spread: 538 bps (as of 6/30/13) 20-year median spread: 538 bps Average default rate: 4.3% Today, the gap between spreads and defaults remains wide, signaling opportunity for investors High-yield default rate Spread to worst Sources: JPMorgan, High Yield Market Monitor, 6/30/13. A basis point (bp) is one-hundredth of a percent. One hundred basis points equals one percent. Spread to worst measures the difference between the best- and worst-performing yields in two asset classes. Below-average defaults and strong fundamentals suggest that spreads could potentially tighten further.
  • 8. 8 Q3 2013 | Fixed-Income Outlook Figure 6: Municipal bond credit spreads widened Municipal bond spreads by quality rating 0 100 200 300 400 500 BBB A AA 201320122011201020092008200720062005200420032002200120001999 Sources: Putnam, as of 6/30/13. Credit ratings are as determined by Putnam. The most attractive relative values appear to be in the BBB-rated segment of the muni market. The key weak spot that gives us pause is China, which we expect will continue to encounter downgrades to its growth outlook. Shortly into the third quarter, China’s GDP growth registered at 7.5%, but outlier forecasts of 3% to 4% growth rates in China going forward indicate the level of skepti- cism over China’s ability to maintain its profile of robust expansion. Commodity export-dependent emerging markets may continue to get caught in the wake of this slowdown, which contributes to our rationale for taking a cautious stance with respect to emerging-market debt. Emerging-market debt: unwinding the carry trade An important thread in the story of global markets over the past decade has involved the so-called “carry trade”: for example, borrowing yen and investing in higher- yielding commodity currencies in the 2002–2007 period or, more recently, borrowing dollars and investing in emerging-market bonds. As continued monetary stimulus in the United States began to look less certain in June, the carry trade in emerging-market debt started to unwind. Consequently, we saw credit spreads start to widen in emerging markets in advance of spread widening in U.S. high-yield and investment-grade corporate debt markets. This growing perception of increasing credit risk put downward pressure on bond prices. From our perspec- tive, the near-term outlook for emerging-market debt argues for caution.
  • 9. PUTNAM INVESTMENTS | putnam.com 9 To the extent that interest rates rise on the long end of the yield curve and people believe in the sustainability of U.S. economic strength, a variety of U.S. assets become more attractive while emerging markets become less attractive to investors. The risk is that talk of QE tapering and its eventual removal leads to real economic consequences for emerging markets and elsewhere. In this way, QE tapering — which has been forecast to begin later this year, provided that data indicate continued U.S. economic strength — runs the risk of causing economic deterioration elsewhere in the world, particularly in the emerging markets. This is not to say that emerging markets no longer present opportunities. Importantly, we believe funda- mentals are generally positive in the emerging markets and that growth rates in these countries will continue to surpass those in the developed world. Emerging-market growth, compared with that of the past, has slowed some- what, particularly where it is linked to China’s demand for commodities. But the underlying credit strength of emerging-market sovereigns still looks quite good, in our view. In our emerging-market portfolios, we have established what we believe is a good mix of sovereign exposures, including a portfolio of U.S.-dollar-denomi- nated debt issued by what we consider to be relatively stable countries, such as Brazil, Mexico, and Peru, in addition to debt issued by some riskier countries. Our aggregate local-currency position, moreover, is tracking relatively close to the benchmark. Municipal bonds: fundamental strength with headline risks to watch Heightened uncertainty on many fronts contributed to a mixed picture for the municipal bond market in the second quarter. In April, the market followed Treasuries to some extent, and benefited as rates moved lower and prices moved higher. However, following the Fed’s discussion around tapering its bond-buying program, there was a notable sell-off from May into June as investors worried about rising rates and a more hawkish Fed. This sell-off erased gains that were made in April. While we expect market volatility among munis in the near term, we continue to have a constructive outlook and believe munis still offer a good option for long-term investors seeking tax-exempt income. Although signifi- cant outflows have compounded the sell-off in municipal bonds, the recent rise in rates has resulted in a decreased supply of bonds for refunding purposes; and total supply is down 11.5% year-over-year through the end of June. Also, the increase in yields may bring in crossover buyers and direct retail investors to help support technicals in the market. Aside from isolated credits such as Detroit and Puerto Rico, fundamentals within the municipal market are generally improving. It is likely that factors such as interest rates and the direction of the economy could continue to influence market activity. A degree of uncertainty over tax policy has been clarified, as income tax rates for 2013 are now certain. However, other policy issues that can affect the value of municipal bonds remain unresolved, including federal budget sequestration, the debt ceiling, and the potential for broader tax reform. We are monitoring developments in these areas. 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, overall default rates remain low. In our analysis, the A-rated and BBB-rated segments of the market continue to offer attractive relative value opportunities. We generally favor higher-yielding sectors and issues with below-average sensitivity to interest rates. Currencies We favor long positions in the U.S. dollar. We think the Fed will be the first of the major central banks to start exiting unconventional monetary policy, and it seems that late summer/early fall is the most likely point for the Fed to begin this process. Over the medium term, the U.S. dollar should be supported by a relatively better growth outlook and a gradual reduction in the pace of accommodation by the FOMC, as well as by the time effect of approaching current forward guidance for the first rate hike in 2015. For the euro, as well, we favor a slightly long position, but not against the U.S. dollar. The single currency remains supported by healthy trade flows — the eurozone is set to run a current account surplus exceeding 2% of GDP this year. In contrast, the upside for the euro remains capped by the risk of further cyclical monetary easing from the European Central Bank. While the beginning of the end of QE may have gotten off to a rocky start, we are generally optimistic about how the transition will progress.
  • 10. 10 Q3 2013 | Fixed-Income Outlook With respect to the Japanese yen, we expect renewed weakness. Over the medium term, the Bank of Japan is expected to do much more easing and this should provide further impetus for the U.S. dollar to rally versus the yen. At this time of writing, the ruling Liberal Democrats had just retaken the Diet’s upper house, creating the prospect of political stability and policy continuity that should, we believe, encourage Japanese investors to take more risk in both the Nikkei and higher-yielding foreign assets. For the Australian dollar, we favor a short position. The market now seems to view the Chinese growth outlook of 7.5% more carefully and no longer expects easier mone- tary or fiscal policy to keep growth rates more elevated. With external support a bit weaker, the RBA has main- tained an easing bias, stating that lower levels of inflation provide room for even easier policy, which should keep pressure on the currency. Amid lower levels of global growth and lower commodity prices and inflation, emerging-market central banks have shifted into easing mode. Emerging-market currencies remain over-owned in a world where U.S. term structure is likely to grind higher. With weaker current account surpluses in emerging markets, large capital outflows are a major risk for emerging-market currencies. Conclusion While the beginning of the end of QE may have gotten off to a rocky start, we are generally optimistic about how the transition will progress. As the general rate environment evolves from ultra low levels to higher — but still historically low — levels, we expect volatility in rates and spreads to remain high. In preparation for this condition, we dialed back risk in a variety of fixed-income sectors, but in some cases have already added risk back to portfolios where we deemed markets presented us with attractive re-entry points. Overall, we see the United States as the safest haven among global markets going forward. If the U.S. economy continues to improve, as we expect it will, the market may anticipate impending action by the Fed to curb QE, in which case we would expect rates to move to and poten- tially exceed the high end of our projected range. In our view, this scenario makes thinking outside the index, with a focus on less interest-rate-sensitive securities and strat- egies, all the more vital to fixed-income investors. Agencymortgage-backedsecurities are represented 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 the 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 JPMorgan Global High Yield 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-exempthighyield is represented by the Barclays Municipal Bond High Yield Index, which consists of below-investment-grade or unrated bonds with outstanding par values of at least $3 million and at least one year remaining until their maturity dates. 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.
  • 11. PUTNAM INVESTMENTS | putnam.com 11 Putnam’s veteran fixed-income team offers a depth and breadth of insight 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 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.
  • 12. Consider these risks before 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 deriv- atives 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 fund’s 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. 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 282869 7/13