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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 bonds 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 bonds 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 & Poors and Moodys. These companies investigate a bond issuers ability to make interest and principal payments.
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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, 2011, income represented 92.3% of government bond total returns, 98.2% of corporate bond total returns and 93.6% of municipal bond total returns.1
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Heres why: Suppose you invest $1,000 in a 10-year U.S. Treasury bond with a 5% 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 6%. Obviously, no one wants to pay $1,000 for a bond yielding 5% when a higher-yielding bond costs the same. So the bonds value has decreased. When interest rates decrease, the reverse happens. If interest rates had fallen and new Treasury bonds with similar maturities were yielding 4%, you could most likely sell your 5% bond for more than your purchase price.
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 3 months 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 one to 10 years. 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 thats 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.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 companys ability to repay its debt.
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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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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 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 & Poors or Moodys. Lower-rated bonds typically offer higher yields to compensate investors for higher risk of default.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 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
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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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.
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% tax bracket, to equal the hypothetical tax-free yield of 4.50%, you'd have to earn 6.25% on a taxable investment.10
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 4.50% and the stated federal income tax rates in effect on 1/1/2011. 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 funds 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 funds 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 funds prospectus. For more information on mutual fund prospectuses and other fund literature see: Reading a Prospectus and Reading a Shareholder Report.
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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.
Footnotes 1. Source: Barclays Capital U.S. Government Index, Municipal Bond Index, U.S. Credit Index, 12/31/2011. Total return includes compounded income and capital appreciation over the 20-year period ended 12/31/2011. 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 funds yield and share price are not guaranteed and will vary with market conditions. 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 funds 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 passthrough 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. 5. Franklin tax-free income funds seek income free from federal regular and, depending on the fund, state and local personal income taxes. 6. For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. 7. Distributions of capital gains are generally taxable. 8. For investors subject to the alternative minimum tax, fund dividends may be taxable. Distributions of capital gains are generally taxable. Dividends are generally subject to state and local taxes, if any. For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable. To avoid the imposition of 28% backup withholding on all fund distributions and redemption proceeds, U.S. investors must be properly certified on Form W-9 and non-U.S. investors on Form W-8BEN. 9. Fund dividends and share price will vary with market conditions. Assumes a fixed rate of return and the stated federal income tax rates. The chart does not reflect the effects of any state or local taxes. 10. Assumes a fixed rate of return based on the stated federal income tax rates in effect on 1/1/2011. State and local taxes, and the effect of the alternative minimum tax, are not reflected. Figures do not reflect fund performance. Fund dividends and share prices will vary with market conditions.
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For U.S. residents only. Copyright 2012 Franklin Templeton Investments. All Rights Reserved.
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