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Fixed Income Funds

Fixed income investments, including fixed income mutual funds, can play an important role in almost any portfolio by providing current income and adding diversification.

How Bonds Work

A bond is a negotiable IOU, or debt security, issued by a corporation, government or government agency. When you buy a bond, you’re lending a certain sum of money (principal) to the bond issuer for a specified time period (term).

The issuer promises to:

  • Repay the face value of the bond on the maturity date, which is when the principal amount of the bond becomes due and payable in full
  • Make regular interest payments during the term at a rate set when the bond is issued

Usually, the interest rate paid by a bond cannot change, which is why bonds are called fixed income investments.

 

How bonds can help you make money. Bonds can help you make money in two ways:

  1. Bonds pay interest. The appeal of most bonds is steady income. You can usually expect to receive regular, semiannual, fixed-interest payments until the bond matures, at which point principal is returned.
  2. They can also appreciate. A bond is not typically designed to appreciate in value, but prior to maturity, its market value may rise or fall depending on market conditions. You may realize a capital gain or a loss by selling a bond before maturity.

About maturity. A bond’s maturity indicates when its issuer is required to repay the principal. Bonds are classified in three general maturity ranges:

  • Short-term — usually less than three years
  • Intermediate-term — between three and 10 years
  • Long-term — greater than 10 years

Maturity affects a bond’s yield and its price stability. Usually, a longer-term bond offers a higher interest rate to compensate you for the risk of tying up your money for a longer period of time at a fixed-interest rate.

Bond ratings. Most corporate bonds are rated by third-party sources, such as Standard & Poor’s and Moody’s. These companies investigate a bond issuer’s ability to make interest and principal payments.

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Understanding a Bond’s Total Return

While a bond’s price will fluctuate with interest rate changes, it’s important to remember that price movement is only part of the picture. Bond investors also receive income, which historically has composed the vast majority of a bond’s total return. Total return includes a bond’s price movement (capital appreciation or depreciation) and income the bond generates.

Because bonds generally pay interest whether prices move up, down or stay the same, bond yields can help to cushion overall total return in down years. Historically, income return has been the largest component of total return for bonds. In fact, for the 20-year period ended December 31, 2012, income represented 96.6% of corporate bond total returns, 91.7% of government bond total returns, and 93.1% of municipal bond total returns.1

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How do Interest Rates Affect Bond Prices?

Typically, bond prices and interest rates move in opposite directions. This means that when interest rates rise, bond prices tend to fall, and conversely, when interest rates decline, bond prices tend to rise.

Here’s why: Suppose you invest $1,000 in a 10-year U.S. Treasury bond with a 2% yield. That interest rate is fixed, even as prevailing interest rates change with economic conditions, especially the rate of inflation. After five years, you decide to sell the bond, but interest rates have risen and similar new bonds are now paying 3%. Obviously, no one wants to pay $1,000 for a bond yielding 2% when a higher-yielding bond costs the same. So the bond’s value has decreased.

When interest rates decrease, the reverse happens. If interest rates had fallen and new Treasury bonds with similar maturities were yielding 1%, you could most likely sell your 2% bond for more than your purchase price.

 

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Kinds of Bonds

You can choose from many kinds of bonds to meet your investment objectives:

Government Bonds. U.S. government bonds are called Treasuries because they are sold by the Treasury Department. Treasuries come in a variety of maturities ranging from 1 month to 30 years. These bonds are guaranteed by the U.S. government and are free of state and local taxes on the interest they pay.2 The Treasury department also offers inflation-indexed bonds called TIPS which are issued in maturities of 5, 10 and 30 years.3

  • Treasury Bills – debt securities maturing in less than one year.
  • Treasury Notes – debt securities maturing in more than one year to 10 years, sometimes called T-notes.
  • Treasury Bonds – debt securities maturing in more than 10 years.

Government agency bonds. These bonds are issued by U.S. government agencies or instrumentalities to fund specific agency programs, including those that facilitate mortgage loans4 (e.g. Ginnie Mae, Fannie Mae and Freddie Mac).

Municipal bonds. These bonds are issued by state and local governments and their agencies, and they often finance public projects such as schools and highways. Municipal bonds provide income that’s generally free from regular federal income tax. In the state of issue, the interest from municipal securities is often free from both state and local income taxes as well.5

Corporate bonds. Corporations also issue bonds to raise capital. The credit quality of the bonds can range from high to low, depending on the company’s ability to repay its debt.

Foreign and emerging market bonds. Foreign governments, government agencies and corporations may also issue bonds. The economic strength and political stability of an issuing country, as well as currency fluctuations, are investment risks that should be considered.

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Advantages of Fixed Income Funds

A fixed income mutual fund is a professionally managed pool of money invested primarily in bonds determined to be appropriate for its investment goal. Fixed income funds offer an affordable and convenient way to access the bond market, as well as other benefits, including:

Monthly income. Most fixed income funds pay monthly dividends, unlike individual bonds, which usually pay interest semiannually.

Professional management. Fund managers actively analyze economic and market conditions and individual securities. Fixed income funds charge management fees, which are not applicable to individual bond investors.

Diversification. A fixed income mutual fund spreads your investment across many bonds, which may help to reduce the risk that one bond’s performance will have a significant negative impact on your investment.

Liquidity. You may sell some or all of your mutual fund shares at any time and receive their current value (net asset value). The value may be more or less than your original cost, which may include a sales charge.

Convenience. Mutual funds offer shareholders many services that make investing easier. You may buy or sell shares each business day, automatically add to or withdraw from your account each month, and have income dividends and capital gains paid out to you or automatically reinvested.

A Few Words about Risk. Interest rate movements will affect a fixed income fund’s share price and yield. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in a fund adjust to a rise in interest rates, a fund’s share price may decline. These and other risk considerations are discussed in each fund’s prospectus. 

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Tax-Free Investing Basics

What is a municipal bond? A municipal bond is an IOU issued by state and local governments and their agencies to raise money to fund public projects such as schools, hospitals and bridges. The entity that issues a bond makes interest payments to bondholders to compensate them for the use of their money until the bond is repaid. These interest payments are generally exempt from regular federal income tax. In addition, for residents of the state in which the bond was issued, interest payments are also typically exempt from state tax.5

What is a tax-free income fund? A tax-free income mutual fund invests primarily in municipal bonds. The funds offer investors income exempt from regular federal income tax and, in many cases, state and local income tax.5, 6, 7

National tax-free funds. These funds invest in municipal bonds issued by state and local governments anywhere in the country. Dividends are free from regular federal income tax.6, 7

State-specific tax-free funds. These funds invest in municipal bonds issued within a single state. As most states do not tax the income generated by their own bonds or those issued by their governmental entities, the income they distribute is generally exempt from regular federal income tax and state tax for residents of that state.6, 7

Insured tax-free funds. These funds invest in municipal bonds covered by insurance policies. In the event of default by a bond issuer, an insured municipal bond is guaranteed to make timely principal and interest payments.6, 7 Dividends are free from regular federal income tax.5, 6

Please note, neither municipal bonds nor municipal bond fund shares are insured by any U.S. or other government agency. Insurance does not protect shareholders from market volatility, and fund shares will fluctuate in value.

High-yield tax-free funds. Typically, these funds invest in lower-rated municipal bonds, as rated by a credit rating agency such as Standard & Poor’s or Moody’s. Lower-rated bonds typically offer higher yields to compensate investors for higher risk of default.6, 7 Dividends are free from regular federal income tax.5, 6

Short- and intermediate-term tax-free funds. These funds specialize in short or intermediate-term municipal bonds. As a general rule, the longer the average maturity of the bonds, the greater the income and expected return, and the greater the potential share price volatility.6, 7 Dividends are free from regular federal income tax.5, 6

Tax-exempt money funds. By purchasing short-term municipal securities, these funds are managed to maintain a steady $1.00 per share net asset value.6, 7 Dividends are free from regular federal income tax.5, 6

An investment in a money fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although these funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in them.

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Why Consider Tax-Free Investing?

If you’re in the 25% or higher marginal federal income tax bracket, a tax-free income fund could offer you a number of financial advantages.

Tax savings. Tax-free income funds provide monthly income free from regular federal income tax, federal Medicare surtax, and, in many cases, state and local taxes.6, 7

Keep more of what you earn. If you held $100,000 in a taxable investment yielding 4.0% for one year, you would have earned $4,000.8 However, depending upon your marginal federal income tax bracket; you could have paid up to $1,736 to Uncle Sam and kept only $2,264 of your investment earnings.

In comparison, with a tax-free investment yielding 3.50%, you would have earned $3,500 after one year and paid $0 in federal taxes.6, 7, 8

 

Hypothetical Taxable Investment
Yielding 4.00%
Hypothetical
Tax-Free
Investment Yielding 3.50%8

* The combined tax rates are based on the 33%, 35%, and 39.6% regular Federal income tax rates (left to right) plus the 3.8% Federal Medicare Surtax. These are based on published rates in effect January 2013.


This chart is for illustrative purposes only and does not represent the performance of any Franklin, Templeton or Mutual Series fund. There is no guarantee that after-tax returns of municipal bonds will be greater than those of taxable investments.

Combined Regular Federal Income Tax plus Federal Medicare Surtax Rates* 36.8% 38.8% 43.4%
Paid in Taxes $1,472 $1,552 $1,736 $0
Kept $2,528 $2,448 $2,264 $3,500

 

Taxable equivalent yield. Municipal bonds may offer taxable equivalent yields that are higher than taxable fixed income alternatives. Checking the taxable equivalent yield can help you make an apples-to-apples comparison between tax-free municipal and taxable bonds. It shows you how much more you would have to earn from a taxable bond to compensate for taxes in order to equal or exceed the tax-free yield of a municipal bond.

For a person in the 28% regular federal income tax bracket, to equal the hypothetical tax-free yield of 3.50%, you’d have to earn 4.86% on a taxable investment as seen in the following chart.9

This chart is for illustrative purposes only and does not represent the performance of any Franklin, Templeton or Mutual Series fund. Assumes a fixed rate of return of 3.50% and the stated combined regular federal income tax brackets plus applicable federal Medicare surtax in effect on 1/1/2013.9 State and local taxes, and the effects of the alternative minimum tax, are not reflected. There is no guarantee that after-tax returns of municipal bonds will be greater than those of taxable investments.

A word about risk. Municipal bonds are sensitive to interest rate movements, and a fund’s yield and share price will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in a fund adjust to a rise in interest rates, a fund’s share price may decline.

In general, securities with longer maturities are more sensitive to interest rate changes. Funds with investments concentrated in a single state are subject to greater risks of adverse economic and regulatory changes in that state than a fund with broader geographical diversification. These and other risks are detailed in a fund’s prospectus. For more information on mutual fund prospectuses and shareholder reports see: Reading a Prospectus and Reading a Shareholder Report.

 

For more information on any of our funds, contact your financial advisor or download a free prospectus. Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. The prospectus contains this and other information. Please read the prospectus carefully before investing or sending money.

 

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Footnotes

  1. Source: Barclays U.S. Government Index, Municipal Bond Index, U.S. Credit Index, 12/31/2012. Total return includes compounded income and capital appreciation over the 20-year period ended 12/31/2012. Indexes are unmanaged, and one cannot invest directly in an index. Past performance does not guarantee future results.
  2. Individual securities owned by a fund that invests in U.S. Treasuries, but not shares of the fund, are guaranteed by the U.S. government as to timely payment of principal and interest. A fund’s yield and share price are not guaranteed and will vary with market conditions.
  3. Individual securities owned by a fund that invests in TIPS (Treasury Inflation-Protected Securities), but not shares of the fund, are guaranteed by the U.S. government as to timely payment of principal and interest. A fund’s yield and share price are not guaranteed and will vary with market conditions. TIPS purchased on the secondary market may experience a total net loss if purchased above par value. The U.S. government does not guarantee against losses incurred in the secondary market.
  4. Government agency or instrumentality issues have different levels of credit support. Ginnie Mae pass-through mortgage certificates are backed by the full faith and credit of the U.S. government. U.S. government-sponsored entities, such as Fannie Mae and Freddie Mac, may be chartered by Acts of Congress, but their securities are neither issued nor guaranteed by the U.S. government. Although the U.S. government has in the past provided financial support to Fannie Mae and Freddie Mac, no assurance can be given that the U.S. government will always do so.
  5. Franklin tax-free income funds seek income free from regular federal income taxes, federal Medicare surtax and, depending on the fund, state and local personal income taxes.
  6. For investors subject to the alternative minimum tax (AMT), a small portion of fund dividends may be taxable.
  7. Distributions of capital gains are generally taxable.
  8. Fund dividends and share price will vary with market conditions. Assumes a fixed rate of return and the stated federal tax rates (regular federal income tax bracket + 3.8% federal Medicare surtax starting 1/1/2013 for those regular federal income tax brackets exceeding 28%). The example does not reflect the effects of any state or local taxes.
  9. Assumes a fixed rate of return based on the stated regular federal income tax and federal Medicare surtax rates in effect on 1/1/2013. State and local taxes, and the effect of the alternative minimum tax (AMT), are not reflected. The formula for the Tax Equivalent Yield calculation is (Tax-Free Bond Yield) ÷ (1 minus [Regular Federal Income Tax Rate plus any applicable Federal Medicare Surtax]). Figures do not reflect fund performance. Fund dividends and share prices will vary with market conditions.

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