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Q3 | 2012Putnam Income Fund Q&A

Renewed investor optimism leads to rally in spread sectors

Portfolio management team


Michael Salm leads a team of veteran investors responsible for day-to-day management of the fund.

Key takeaways U.S. Treasury rates rebounded from record lows as investors regained a sense of optimism. Spread sectors, particularly in the mortgage-backed securities market, rallied amid renewed risk taking and the Federal Reserves announcement of further stimulus. Investment-grade and high-yield corporate bonds continued their streak of strong performance, and our outlook for the credit sector remains favorable.

Michael V. Salm (industry since 1989)

Daniel S. Choquette, CFA (industry since 1997)

Our base-case outlook anticipates a slow but positive growth environment in the United States, in which case credit and prepayment risks remain preferable to term structure exposure. How did the bond markets perform in the third quarter of 2012?

Brett S. Kozlowski, CFA (industry since 1997)

Kevin F. Murphy (industry since 1988)

The European debt situation and lackluster growth in the U.S. economy continued to capture headlines, but investors were encouraged by signs of progress on both fronts. Expectations in the first half of the year had become decidedly pessimistic, and the lack of any catastrophic developments during the summer months led investors to back into riskier assets, which outperformed safe-haven Treasuries in the third quarter. Both stock and bond markets have been volatile in 2012 as investors have fluctuated between risk-on and risk-off trades, moving capital into and out of riskier markets en masse. While this trend may continue into 2013, we believe there is mounting evidence to suggest that fundamentals, rather than macroeconomic pressures, are increasingly dictating performance an encouraging sign for investors. The Federal Reserve recently announced a new round of quantitative easing. What affect will that likely have on the broader economy and the bond markets? This third round of quantitative easing, dubbed QE3, aims to keep interest rates low in order to encourage investor risk taking and investment in the economy. Like the two rounds of easing that preceded it, the Fed will purchase bonds, targeting in this iteration the agency mortgage-backed securities market. The length of

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Q32012| Renewed investor optimism leads to rally in spread sectors

the bond buying program is uncertain, but will likely continue until the labor market shows substantial improvement. The important factors are, first, the velocity of money, or how quickly credit is able to move through the financial system; and, second, the psychological signal that the Fed is sending. Investors have come to expect that the Fed will do everything within its power to pursue its dual mandate of stable prices and maximum employment, and launching QE3 has thus far been interpreted as an encouraging sign. With that in mind, how did the funds positioning in agency mortgages affect performance during the quarter? Agency mortgage-backed securities posted gains during the quarter in anticipation of increased demand from the Feds buying program. While the funds holdings performed well on an absolute basis, we did have a modest underweight in the sector relative to the benchmark, which detracted somewhat from relative performance. However, the funds exposure to agency CMOs, such as interest-only [IO] securities more than made up for that drag on returns. Investment-grade corporate bonds represent one of the funds largest allocations. How did the sector perform? Investment-grade corporate bonds continued to post solid gains during the third quarter. Coming out of the financial crisis in 20082009, corporations took aggressive steps to shore up their balance sheets and rein in expenses, and today theyre running very lean, profitable organizations, with the added benefit of having record levels of cash on hand. Its been a very attractive combination for investors, especially given the record-low yields in the Treasury markets, and our position benefited performance for the quarter as spreads tightened further. The story in the high-yield corporate space, to which the fund has a modest allocation, is essentially the same: The 2008 credit crisis served to purge the highyield universe of the least stable companies, and the remaining cohort has performed extremely well since,
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with defaults well below the long-term average. One area we find particularly attractive is among those companies on the verge of being upgraded from the high-yield to the investment-grade space the BB-rated universe. As you would expect, the financial outlook for these types of companies is solid and, importantly, improving, and we find the yield advantage that these securities offer quite attractive relative to the potential risks entailed. How did the funds holdings in other spread sectors perform? Performance in the non-agency residential mortgagebacked sector was solid in the third quarter. The mortgage market in general had performed well throughout the quarter as investors became more willing to take risk. Once the Fed announced the details of QE3, mortgagebacked securities received an additional boost, including non-agency securities that lie outside the scope of the Feds purchase plan. The funds positions in interest-only collateralized mortgage obligations, or CMO IOs, also helped returns. As the name suggests, these securities are derived from the interest payments on those pools of residential mortgages. Essentially, the longer it takes for homeowners to repay the principal on their mortgages, the more money a bondholder will make from interest payments on that loan. Over the past several quarters, with home prices still under pressure and refinancing difficult for many homeowners to obtain, IO securities have performed quite well. IOs gave back some of their gains in September as mortgage spreads tightened, leading to fears of higher prepayment rates if mortgage rates for homeowners were to decline significantly. Lastly, commercial mortgage-backed securities [CMBS] also posted positive returns. CMBS tend to key off the strength of the macroeconomic environment in the United States, and while growth has been frustratingly slow, it has proven to be less fragile than investors had feared earlier in the year. Moreover, the supply and demand characteristics have been supportive of prices, and weve continued to see buy-and-hold investors entering the CMBS market in recent months, which has helped lend further stability to prices.
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Q32012| Renewed investor optimism leads to rally in spread sectors

What is your outlook for the rest of 2012 and into 2013? As has been the case for some time, we continue to believe the opportunities in non-government sectors remain the most attractive areas of the bond markets. While the spreads, or yield advantage, in many sectors of the market have tightened in recent months, relative to their historical norms prior to the 2008 dislocations they still appear very attractive. Investors seem to be slowly returning to the idea of employing long-term strategies rather than timing the next risk trade, and we believe that makes for a more constructive investment environment in general, and particularly for active managers like Putnam. In terms of positioning, we continue to prefer both credit risk, gained through exposure to corporate bonds, commercial mortgage-backed securities, and non-agency mortgage-backed securities, and prepayment risk, which is associated with certain types of collateralized mortgage obligations, over interest-rate risk. While the potential for short-term price volatility still remains high, we believe that our actively managed, risk-conscious approach remains a prudent strategy for investing in todays bond markets.

Putnam Income Fund (PINCX)


Annualized total return performance as of September 30, 2012 Class A shares (inception 11/1/54)
Last quarter 1 year 3 years 5 years 10 years Life of fund

Before sales charge


3.55% 9.09 9.25 7.83 5.92 7.90

After sales charge


-0.57% 4.78 7.76 6.95 5.49 7.82

Barclays U.S. Aggregate Bond Index


1.59% 5.16 6.19 6.53 5.32

Total expense ratio: 0.87%

Quarterly returns are cumulative. Current performance, which may be lower or higher than the quoted past performance, 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. After-sales-charge returns reflect a maximum sales charge of 4.00%. Performance of other share classes will vary. For the most recent month-end performance, visit putnam. com. The funds expense ratio is based on the most recent prospectus and is subject to change. The Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed-income securities. You cannot invest directly in an index.

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Q32012| Renewed investor optimism leads to rally in spread sectors

The opinions expressed here are those of the portfolio managers as of September 30, 2012, and are subject to change with market conditions. Market forecasts cannot be guaranteed and are not to be construed as investment advice. Consider these risks before investing: Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. The use of derivatives involves additional risks, such as 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. The prices of bonds may fall or fail to rise over extended periods of time for a variety of reasons, including both general financial market conditions and factors related to a specific issuer or industry. 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.
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