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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.

Bond prices and interest rates. Bond prices can fluctuate in response to credit quality, market supply and demand, and shifts in interest rates. Interest rate changes usually have the most impact on bond prices. Generally, the longer a bond's maturity, the higher the interest-rate risk, or the more sensitive its price will be to interest rate changes.

The inverse relationship between interest rates and bond prices is illustrated below. Interest rates and bond prices behave like two sides of a seesaw—when interest rates decline, values of existing bonds usually rise. When rates climb, values usually fall.

The Ups and Downs of Bonds

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Types of Bonds

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

U.S. Treasury securities. These bonds are issued by the U.S. government and are generally considered the safest of all bonds since they're backed by the full faith and credit of the U.S. government as to timely payment of principal and interest.1

  • U.S. Treasury bills—short-term investments that mature in one year or less
  • U.S. Treasury notes—intermediate-term investments maturing in one to 10 years
  • U.S. Treasury bonds—long-term investments that mature in 10 to 30 years

U.S. government agency bonds. These bonds are issued by U.S. government agencies or instrumentalities to fund specific agency programs, including those that facilitate mortgage loans.

Issuers include the Government National Mortgage Association (GNMA, "Ginnie Mae"), Federal National Mortgage Association (FNMA, "Fannie Mae") and the Federal Home Loan Mortgage Corporation (FHLMC, "Freddie Mac").2

Treasury Inflation-Protected Securities (TIPS). TIPS are a popular way for investors to combat inflation. Like traditional Treasury bonds, TIPS are issued by the U.S. Treasury and are guaranteed by the U.S. government.3 But TIPS have a special feature that provides protection against inflation. The principal value of TIPS are periodically adjusted according to the rate of inflation. In contrast, a Treasury bond's principal value is fixed.

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

Floating-rate bank loans. Floating-rate bank loans aren't technically bonds. Floating-rate loans are arranged by banks and other financial institutions to help companies finance restructurings, acquisitions or other highly leveraged transactions. The interest rates on floating-rate loans reset periodically to the underlying benchmark rate, such as the London Interbank Offering Rate (LIBOR). Many floating-rate loans are rated below investment grade, due to the higher levels of debt on the balance sheet of the issuer.

Tax-free municipal bonds. Municipal 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 federal regular income tax. In the state of issue, the interest from municipal securities is often free from both state and local income taxes as well.4

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 to be considered.

Footnotes

1. 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 that invests in U.S. treasuries as to timely payment of principal and interest. A fund's yield and share price are not guaranteed and will vary with market conditions.

2. 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 recently provided financial support to Fannie Mae and Freddie Mac, no assurance can be given that the U.S. government will always do so.

3. Individual securities owned by a fund that invests in TIPS, 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. Franklin tax-free income funds seek income free from federal regular and, depending on the fund, state and local personal income taxes. For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable.

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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 that have been 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.

Easy access to your money. You may sell some or all of your mutual fund shares at any time and receive their current value (net asset value), which may be more or less than your original cost. In some cases, a sales charge may apply. Selling an individual bond at a fair price may be much more difficult. Front-end, and in some cases, back-end sales loads, management fees, Rule 12b-1 fees and other expenses are associated with Franklin Templeton mutual funds. Investment returns for a fund are reduced by these fees and expenses. The funds are offered through prospectuses.

Automatic reinvestment of dividends. You may choose to receive a monthly dividend check or reinvest dividends automatically.

Flexibility. If your investment objectives change, you can usually exchange into other funds in the same class in a fund family, generally without fees or charges. Some funds offer multiple share classes, subject to different fees and expenses. Certain exceptions and restrictions apply to the exchange program, as stated in the prospectus, and it may be modified or discontinued by the fund(s). Exchanges between funds within a family will normally result in taxable events.

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Speak with Your Financial Advisor

Nearly all investors can benefit from having a portion of their portfolio allocated to bonds. Even for investors whose primary objective is long-term growth, bonds can play an important role in building a well-diversified portfolio. As always, you will want to consult your financial advisor about how fixed income funds could play a role in your investment strategy.

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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Important Legal Information

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

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