Q3 | 2012Putnam municipal bond funds Q&A

Municipal bonds continue winning streak, though policy risks loom at year-end
Portfolio management team
Thalia Meehan leads a team of veteran investors responsible for day-to-day management of the fund.

Key takeaways Municipal bonds continued to post gains in the third quarter, drawing in investors with attractive yields versus Treasuries. Supply and demand technicals have benefited municipal bonds thus far in 2012. The municipal market will likely be influenced by the fiscal cliff the closer we get to the election, and potentially beyond.

Thalia Meehan, CFA (industry since 1983)

Paul M. Drury, CFA (industry since 1989)

We continue to overweight essential-service revenue bonds, and maintain our bias toward the A-rated and BBB-rated segments of the market. Municipal bonds continued their streak of solid gains in the third quarter. What was driving those returns?

Susan A. McCormack, CFA (industry since 1986)

Municipal bonds have benefited from the fact that they offer higher yields than Treasuries, but still entail relatively low risk of default. As a result, investors have flocked to the asset class, pouring nearly $40 billion into the municipal bond market in 2012, which are among the highest totals in the past 20 years. Clearly, demand has been very strong. Supply, meanwhile, has been relatively limited, especially within high-yield municipal bonds. In 2006 and 2007, non-rated bonds were being issued at a rate of $5 billion to $6 billion a year, our research shows. Today, new issuance is roughly $1.8 billion through September of this year. On the investment-grade side, a significant majority of issuance in 2012 has been for the purpose of refinancing existing debt at lower interest rates. This inequity between supply and demand has helped keep upward pressure on prices. At the same time, municipal bond valuations have continued to appear attractive relative to corporate and Treasury debt, particularly on a tax-adjusted basis. Valuations, of course, are only one factor among many, but it has been one of the factors drawing investors into the market.

PUTNAM INVESTM ENTS| putnam.com

Q32012| Municipal bonds continue winning streak, though policy risks loom at year-end

Theres been a lot of discussion about the looming fiscal cliff, referring to tax increases and spending cuts slated to begin on January 1, 2013. Can you give us an update on the situation? The closer we get to the November elections, the more attention we imagine the fiscal cliff will get. Obviously, investors would prefer the issue be addressed sooner rather than later, but its anyones guess as to whether the lame-duck session of Congress will put together legislation before January. Theres certainly incentive to take up the issue soon: The Congressional Budget Office estimates that the combined effect of the spending cuts and taxes hikes would negatively impact GDP. The market is hopeful that an extension deal can be reached after the election, and that a longer-term solution to debt levels tax rates can be taken up in the first part of 2013. How concerned are you about the potential for higher interest rates in the municipal bond market? We believe that given all thats going on at the macroeconomic level today, the likelihood of higher interest rates is relatively low. There is still quite a bit of uncertainty surrounding the sovereign debt situation in Europe, and in the United States the Federal Reserve recently announced a third round of quantitative easing, or QE3. In conjunction with the new round of bond buying, the Fed reiterated its intention to keep short-term rates at near-zero levels into 2015. So ultimately, there are a number of factors applying downward pressure on interest rates through central bank easing policies. That said, there are a number of strategies we can employ to reduce the interest-rate sensitivity of the portfolios should we believe conditions warrant a more defensive stance. And, of course, not all bonds are created equal when it comes to interest-rate sensitivity. To lessen the funds sensitivity to rate movements, we can reduce our exposure to long-dated bonds and buy intermediate-term bonds, or move from higher-rated positions to somewhat higher-yielding positions, which tend to be more defensive in a rising-rate environment.

How are you positioning the portfolios from a sector and credit quality perspective? For some time now, weve been focusing our investments on essential service revenue bonds, which we believe are more insulated from fiscal pressures at the municipal level. While tax receipts have been gradually improving along with the slow growth were seeing in the broader economy, we believe local debt and particularly local general obligation debt is more vulnerable to any bumps on the road. From a credit quality perspective, we believe the A-rated and BBB-rated segments of the market, even after more than three years of spread tightening, still may have room to go and continue to appear attractively valued compared with other segments of the municipal bond market. What is your outlook for the remainder of 2012 and into 2013? We continue to be optimistic on the outlook for municipal bonds, given strong market technicals, and maintain our overweight to essential service revenue bonds. While spreads are well off their wides, they remain attractive. Supply may experience a seasonal increase in October and November, but if demand for bonds remains strong as we believe it will given recent cash flows into the asset class then December and January may once again see increased reinvestment demand. Like most asset classes, the municipal market will likely be more heavily influenced by the fiscal cliff the closer we get to the election, particularly as it appears unlikely to be addressed before November 6. Increasingly, investors have been looking to Washington, D.C. for clues about a potential short-term extension of tax rates, the future of slated sequestration, the possible need to raise the debt ceiling, and the potential for broader tax reform in 2013. All of these factors could impact the value of municipal bonds tax exemption, the availability of bonds, and the transfer of federal dollars to state and local municipalities, and therefore credit quality in general. As always, we are monitoring the political situation closely, and believe that given the less-than-certain environment going forward, our funds are well positioned for helping investors pursue diverse tax-free income opportunities.

PUTNAM INVESTM ENTS| putnam.com

Q32012| Municipal bonds continue winning streak, though policy risks loom at year-end

Annualized total return performance as of September 30, 2012 Putnam Tax Exempt Income Fund (PTAEX)
Class A shares (inception 12/31/76)
Last quarter 1 year 3 years 5 years 10 years Life of fund

Putnam Tax-Free High Yield Fund (PTHAX)

Class A shares (inception 9/20/93)
Last quarter 1 year 3 years 5 years 10 years Life of fund

Before sales charge

2.53% 10.09 6.40 5.66 4.79 6.92

After sales charge

-1.56% 5.67 4.95 4.80 4.37 6.80

Barclays Municipal Bond Index

2.31% 8.32 5.99 6.06 5.03

Before sales charge

2.90% 13.13 8.67 5.52 5.29 6.43

After sales charge

-1.20% 8.63 7.19 4.68 4.86 6.27

Barclays Municipal Bond Index

2.31% 8.32 5.99 6.06 5.03 7.14

Total expense ratio: 0.75%

Total expense ratio: 0.80%

Quarterly returns are cumulative. Current performance may be lower or higher than the quoted past performance, which 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. Performance of class A shares after sales charge assumes reinvestment of distributions and does not account for taxes. After-sales-charge returns reflect a maximum 4.00% load. For Putnam Tax-Free High Yield Fund, the life-of-fund performance for class A shares is based on the historical performance of class B shares (inception 9/9/85), adjusted for the applicable sales charge. To obtain the most recent month-end performance, visit putnam.com. The funds expense ratios are based on the most recent prospectus and are subject to change. The Barclays Municipal Bond Index is an unmanaged index of long-term fixed-rate investment-grade tax-exempt bonds. It is not possible to invest directly in an index. Past performance is not indicative of future results. The views and opinions expressed here are those of the portfolio managers as of September 30, 2012, are subject to change with market conditions, and are not meant as investment advice. Consider these risks before investing: Capital gains, if any, are taxable for federal and, in most cases, state purposes. For some investors, investment income may be subject to the federal alternative minimum tax. Income from federally tax exempt funds may be subject to state and local taxes. 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. Since the funds invest in tax-exempt bonds, which, to be treated as tax-exempt under the Internal Revenue Code, may be issued only by limited types of issuers for limited types of projects, the funds' investments may be focused in certain market segments. Consequently, the funds may be more vulnerable to fluctuations in the values of the securities they hold than a fund that invests more broadly. 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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