Q3 | 2012Putnam Government Bond Funds Q&A

Mortgage-backed securities rallied as Fed announced new bond-buying program

Michael V. Salm Co-Head of Fixed Income Portfolio Manager Daniel S. Choquette, CFA Portfolio Manager

The United States continues to be among the most attractive developed bond markets for investors.

Key takeaways U.S. Treasury rates hit new lows in July before rebounding to finish the third quarter. The mortgage-backed securities market posted strong gains in anticipation of a new round of quantitative easing from the Fed. While prices in the housing market nationally have yet to mount a sustained rally, we believe the fundamentals are in place to allow for future price improvements. Our base case economic outlook in the United States calls for continued slow and steady growth, although policy uncertainties remain. Interest rates were rather volatile during the quarter, touching new lows in July before climbing higher. How did that affect the performance of Putnams government bond funds? We seek to position both funds so that they arent dependent exclusively on declining interest rates to drive returns. In Putnam American Government Income Fund, we seek to achieve that by diversifying beyond investments in the Treasuries market, a sector that is highly influenced by interest-rate movements. In Putnam U.S. Government Income Trust, we seek a mix of positions that have the potential to perform in a variety of interest-rate environments. With that in mind, both funds were able to generate positive returns during the third quarter despite the volatility in interest rates, primarily through our allocation to agency mortgages, which rallied sharply during the quarter.

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Q32012| Mortgage-backed securities rallied as Fed announced new bond-buying program

Speaking of the mortgage market, the Federal Reserve announced a new round of quantitative easing recently. Can you give us some details on the program and its impact on the bond markets? After its September meeting, the Fed announced it would proceed with a third round of quantitative easing, or QE3. Quantitative easing is in effect a bond-buying program through which the Fed makes targeted purchases in the bond markets with the goal of increasing demand, and thereby driving prices up and yields down. This latest round of bond buying was widely anticipated by investors and will focus on agency mortgage-backed securities. The Fed plans to add some $40 billion worth of securities to its balance sheet per month, with no stated end date for the program. The hope is that driving yields down on mortgage-backed securities will eventually help the housing market by pulling mortgage rates even lower. At the same time, the Fed hopes to spur further risk-taking among investors by coaxing them out of lower-volatility bond market sectors and into areas like high-yield corporate bonds and equities. It remains to be seen how successful the Fed ultimately will be in achieving these goals, and how long QE3 will last. Its worth noting that inflation expectations, which had been relatively benign throughout 2012, increased significantly in the wake of the Feds announcement. Inflation expectations often are reflected in long-term interest rates, which continue to be quite low on a historical basis, but rose on the very long end of the yield curve following the QE announcement. Other measures, such as the spread between the Treasury market and the inflationprotected, or TIPS, market, better reflected this change in outlook. While we havent seen a large jump in long rates yet, we believe its prudent to have a more cautious stance with regard to interest rates in this environment. With this as a backdrop, the funds holdings in the agency mortgage-backed space performed well, as demand was solid in anticipation of the Feds announcement. Security selection was a positive, as we maintained a bias toward mortgages with lower coupons, or interest rates, which are less likely to be refinanced.

How has the housing market performed recently? Have we hit bottom? On the national level, home prices have been relatively stable for some time now. While stability doesnt mean that prices have been appreciating, we believe its an encouraging sign that the foundation has been laid for housing market growth in the not-too-distant future. In fact, were already seeing improvement in certain markets, and valuations relative to the rental market and income levels are reasonable, in our analysis, which is a marked improvement over the distressed levels we were seeing three or four years ago. On the lending side of the equation, were seeing a similar phenomenon. Obviously, the availability of mortgages plays a significant role in the demand for housing. For the past few years, bank lending had been contracting as banks sought to shore up their own balance sheets, and it was very difficult for borrowers with less than perfect credit to obtain a mortgage. While banks continue to be very discriminating, the volume of lending has begun to increase, which is an encouraging sign for the housing market overall. The funds invest in interest-only securities, a type of mortgage-backed security. How did that positioning affect performance? The funds positions in interest-only collateralized mortgage obligations, or CMO IOs, contributed positively to performance in the third quarter. By way of background, 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. But in the third quarter, refinancing activity was somewhat higher than anticipated, and the performance of CMO IOs was more mixed.

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Q32012| Mortgage-backed securities rallied as Fed announced new bond-buying program

One of the main reasons we hold CMO IOs in the funds is because the sector serves as a kind of hedge on the direction of housing. If the economy strengthens and home prices recover, that generally benefits the MBS market. If housing prices remain more stagnant and homeowners struggle to refinance, that tends to benefit CMO IOs. What is your outlook for the economy and the bond markets during the remainder of 2012 and into 2013? We continue to be cautiously optimistic on the U.S. economy, which has been gradually improving. Clearly, there are a number of long-term fiscal issues that the federal government needs to address, including

entitlement spending and the debt load overall. Nevertheless, the United States continues to be among the most attractive developed bond markets for investors. Failure to address the fiscal cliff in a timely fashion or another round of political posturing around the debt ceiling would certainly capture headlines, but we dont believe it makes the U.S. debt markets particularly less attractive relative to the other options available. We continue to believe interest rates are unlikely to be a significant source of returns going forward, but that there is ample opportunity for our investment process to add value. Our capacity for bottom-up security selection gives us the ability to identify and invest in securities that we believe can diversify the source of returns in the funds.

Annualized total return performance as of September 30, 2012 Putnam U.S. Government Income Trust (PGSIX)
Class A shares (inception 2/8/84)
Last quarter 1 year 3 years 5 years 10 years Life of fund Total expense ratio: 0.85%

Putnam American Government Income Fund (PAGVX)

After sales charge
-2.73% -0.57 4.63 6.68 4.97 7.00

Before sales charge

1.33% 3.54 6.06 7.55 5.40 7.16

Barclays GNMA Index

1.07% 4.01 5.87 6.76 5.38 8.24

Class A shares (inception 3/1/85)

Last quarter 1 year 3 years 5 years 10 years Life of fund Total expense ratio: 0.85%

Before sales charge

0.74% 2.48 5.56 7.31 5.08 6.65

After sales charge

-3.25% -1.63 4.15 6.43 4.65 6.49

Barclays Government Bond Index

0.60% 2.95 5.15 6.01 4.74 7.64

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-salescharge 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 GNMA Index is an unmanaged index of Government National Mortgage Association Bonds. The Barclays Government Bond Index is an unmanaged index of U.S. Treasury and agency securities. You cannot invest directly in an index.

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Q32012| Mortgage-backed securities rallied as Fed announced new bond-buying program

The opinions expressed here are those of Michael V. Salm, Co-Head of Fixed Income, Portfolio Manager, and Daniel S. Choquette, CFA, Portfolio Manager, 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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