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Quarterly Report Q1 2014

Wells Fargo Advantage Intermediate Tax/AMT-Free Fund

Portfolio positioning

  • The fund’s duration is shorter than the benchmark. While we may extend duration given the right opportunities, we are likely to keep the fund’s duration somewhat shorter than its benchmark. Although we think longer rates have peaked for the near term, we would not be surprised to see yields increase modestly.

  • In terms of the yield curve, we have a barbell position in place in anticipation of curve flattening. VRDNs, which provide liquidity and a potential hedge against rising-rates, and FRNs make up the front end, paired with fixed-rate debt in the 10- to 25-year segment, which we believe is attractively valued right now. We are underweight—and are avoiding adding—bonds with maturities between three and seven years because they have become expensive. While we are overweight the 17-plus-year segment of the curve (our benchmark does not include these longer- term bonds), we have avoided adding bonds with maturities greater than 25 years because we do not think yields compensate for additional duration risk.

  • Sector allocations are closer to neutral than they have been recently. The subsectors are where our strategy differentiates itself by being overweight prepaid gas bonds, education, and local GOs and underweight state GOs, prerefunded bonds, and transportation.

  • We are selectively adding BBB-rated credits when their yield pickup creates a favorable income opportunity and potential for spread tightening.

  • Issuer selection aims to identify relative-value opportunities.

Still a wild card, flows into municipal bond funds turned positive

Billions ($)

10 5 0

  • 5

  • 10

  • 15

  • 20

Long-term municipal bond fund flows

Source: Investment Company Institute Past performance is no guarantee of future results.

Outlook

We expect the U.S. economy will continue to grow modestly. Not only will Federal Reserve policy remain accommodative despite a gradual reduction of its bond-buying program but also fiscal restraint has lessened, both of which support the economy. While we would not be surprised to see modestly higher interest rates, we think much of the near-term change has been priced into the market already. As a result of these stable conditions, we expect municipal bonds will also benefit because the majority of issuers’ credit fundamentals are strong and improving.

Supply trends will likely support the municipal market as well. Supply is expected to be less than $300 billion this year, which would represent negative net new issuance. On the demand side, municipal bond fund flows were positive during the first three months of 2014, after 10 consecutive months of redemptions due to investor worries about higher interest rates and credit problems in the city of Detroit and Puerto Rico. The direction of future flows into or out of municipal bond funds will be an important determinant of demand in this asset class.

While we usually discuss events within the municipal market here, we would like to highlight five reasons we believe municipals are an attractive asset class now.

  • 1.

    Higher tax brackets (top earners pay a 39.6% income tax rate plus another

    • 3.8

      % investment income surtax as part of the Affordable Care Act) have put municipal taxable-equivalent yields on par with high-yield and emerging markets debt.

  • 2.

    The steep yield curve offers investors in intermediate- and longer-dated funds the likelihood of coupon payments offsetting price declines, should interest rates move modestly higher.

  • 3.

    Credit spreads remain attractive from a long-term perspective; we particularly believe there is value in BBB-rated and certain high-yield bonds.

  • 4.

    Legislative changes to reduce municipal tax exemptions are unlikely this year because it is a mid-term election year.

  • 5.

    Municipal bond funds offer an important source of diversification that may help reduce portfolio risk.

As we look further ahead in 2014, we believe there are exciting opportunities in municipals. Yields are attractive compared with other fixed-income asset classes, and aggregate credit metrics appear healthy. We expect there will be periods of market volatility, which may provide an opportunity to buy or sell attractively valued municipal securities. We will continue focusing on carefully managing interest-rate risk, positioning the fund along the yield curve in a barbell manner that includes bonds with maturities in steeper parts of the yield curve, and using our experienced research team to uncover municipal bonds with good relative values from among the many municipal bond issuers.

5

Wells Fargo Advantage Intermediate Tax/AMT-Free Fund

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