Core bond funds know what you re investing in

Core bond fixed income Wells Fargo Advantage Core Bond Fund February 2015 Core bond funds know what you re investing in Wells Fargo Advantage Funds Fixed-Income Team Just about every retirement plan participant will likely have an allocation to core bonds at some point. However, we ve noticed an important trend in Morningstar s intermediateterm bond category within which the core bond strategies fall. A significant number of funds within the category seem to have boosted their total returns by dipping lower in credit quality, adding considerable amounts of high-yield debt. In our assessment, participants who are seeking the diversification benefits and risk parameters of a true core bond strategy may be unknowingly taking on unintended asset-class exposure by selecting funds that use core-plus allocations to increase returns. It s important to know the distinctions among the funds and to be able to identify the right attributes when selecting a style-pure core bond strategy. In this paper, we review the diversification benefits of core bonds, compare the correlations of various fixedincome asset classes with equities, and discuss ways to identify and select a true core bond strategy. Key points: Retirement plan participants who invest in funds that fall in the Morningstar intermediate-term bond category may be taking on unintended asset-class exposure to high yield when they select strategies that excessively use core-plus allocations to increase returns. Participants seeking the diversification benefits of core bonds to equities should be aware that those typical diversification benefits may diminish as credit quality declines below investment grade. We encourage participants to check their core bond funds to see if non-investment-grade allocations are currently higher than 10%. We believe that participants seeking true core bond characteristics should consider strategies that predominantly maintain an exposure of less than 10% in high yield. FOR INVESTMENT PROFESSIONAL USE ONLY NOT FOR USE WITH THE RETAIL PUBLIC

Participants who invest in core bond funds should watch for significant declines in credit quality Strategies benchmarked against the Barclays U.S. Aggregate Bond Index (Aggregate Index) are likely a participant s first or second thought when considering an allocation to fixed-income securities, and rightfully so. Core bond strategies are typically the base camp of fixed-income investments from which participants can branch out to explore other strategies, often by going shorter or longer in duration weights or higher or lower in credit exposure, investing outside the U.S., or adjusting other risk-toreturn considerations. Within Morningstar s intermediate-term bond category (this is the largest of the fixed-income categories, with more than 300 funds and around $1 trillion in assets), a significant number of funds have been increasing their exposure to high-yield debt. This supplemental use of below-investment-grade securities is a legitimate way of allocating portfolio risk and transforming a core bond strategy into a coreplus strategy. However, some core bond strategies have been known to quietly drift toward more core-plus exposure, which increasingly leads them away from the diversification and risk characteristics that a core bond investor would expect. Thus, participants who are seeking the characteristics of a true core bond strategy should be aware that they may inadvertently take on unintended exposure to high yield by not accurately identifying the right core bond funds. The diversification benefits of bonds may diminish as credit quality decreases participants who are seeking the characteristics of a true core bond strategy should be aware that they may inadvertently take on unintended exposure to high yield by not accurately identifying the right core bond funds. As investors familiar with the basics of portfolio theory know, bonds can serve to dampen the volatility of and serve as a diversifying complement to a portfolio of equity investments. Those fundamental assumptions about bonds generally appear to hold true in much of the investment-grade segments of the bond markets. However, as credit quality decreases, those diversification benefits may diminish. For example, from January 1, 2000, through December 31, 2014, the Barclays U.S. Treasury Index (UST Index) had a correlation with the S&P 500 Index (representing the equities market) of -0.69, offering significant negative correlation. The Aggregate Index (representing a style-pure core bond allocation) also provided a negative correlation with the S&P 500 Index of -0.36. However, the Barclays U.S. Corporate High Yield Index (High Yield Index) had a positive correlation of 0.72. Thus, high-yield bonds have had a much stronger positive correlation with the equities markets and have not provided the same diversification benefits as the investment-grade bond sectors. This intuitively makes sense. Typically, lower-rated credits are far more sensitive to economic risk than interest-rate risk. When the economy does poorly, lower-rated credit prices typically decline; when the economy does well, lower-rated credits usually rally. Equities share those characteristics. 2

Table 1 The core-plus composite and the High Yield Index had stronger correlations to equities than core bonds did Correlations with the S&P 500 Index 12-month rolling returns (%), 1-1-00 to 12-31-14 Barclays U.S. Treasury Index -0.69 Barclays U.S. Aggregate Bond Index -0.36 Wells Fargo Advantage Core Bond Fund (Inst Class) -0.22 Core-plus composite 1 0.30 Barclays U.S. Corporate High Yield Index 0.72 Sources: Barclays and Wells Fargo Funds Management, LLC Past performance is no guarantee of future results. Securities issued by the U.S. government are guaranteed as to the timely payment of principal and interest. In the intermediate-term bond category, we identified dozens of funds with significant allocations to below-investment-grade debt. All funds that held 10% or more in debt rated BB and below and that had at least 10 years of performance data were sorted into a category and labeled the core-plus composite. 1 As we anticipated, the core-plus composite had a much stronger positive correlation with the S&P 500 Index than the Aggregate Index and the UST Index had with the S&P 500 Index, coming in at 0.30. Thus, these core-plus composite strategies offered less diversification to equities than strategies more closely resembling the risk profile of the Aggregate Index. the core-plus composite had a much stronger positive correlation with the S&P 500 Index than the Aggregate Index and the UST Index had with the S&P 500 Index Chart 1 The Aggregate Index had a negative correlation with the S&P 500 Index while the core-plus composite had a positive correlation 1.0 0.72 Correlation to S&P 500 Index 0.5 0.0-0.5 0.30-0.36-0.69-1.0 High Yield Index Core-plus composite Aggregate Index UST Index Sources: Barclays and Wells Fargo Funds Management, LLC Past performance is no guarantee of future results. Securities issued by the U.S. government are guaranteed as to the timely payment of principal and interest. 1. The core-plus composite discussed in the paper was constructed by screening for funds within Morningstar s intermediate-term bond category that held at least 10% of their assets in either non-u.s. or BB-rated and below fixed-income securities over the past four quarters as of 12-31-14. The average was computed based on fund families that had reportable data. Funds must have a minimum track record from 1-1-00 to 12-31-14. Funds that satisfied the conditions are defined as the core-plus composite and include 57 funds. Past performance is no guarantee of future results. An investment cannot be made in the core-plus composite. 3

Lower-rated bonds can increase portfolio volatility Using a core-plus strategy as a stand-in for a core bond allocation could unintentionally amplify a participant s overall exposure to high yield. Incremental returns usually are accompanied by incremental assumptions of risk. It s important to distinguish which funds within the intermediate-term bond category are adding incremental return by broadening their exposure to riskier credit tiers rather than actively garnering return within the style-pure core bond universe. It stands to reason that adding high-yield bonds may increase a portfolio s expected return over time, but at what level of incremental risk? Additionally, is that exposure to high yield already present within an investor s portfolio through other intentionally selected investment allocations to high yield? Using a core-plus strategy as a stand-in for a core bond allocation could unintentionally amplify an investor s overall exposure to high yield. Table 2 shows annualized returns and volatility (measured as standard deviation of returns) since 2000 for the Aggregate Index, the High Yield Index, and the S&P 500 Index. Notice that the volatility of the High Yield Index is nearly three times the volatility of the Aggregate Index. Table 2 High yield s volatility has been more similar to the volatility of the S&P 500 Index than to the volatility of the Aggregate Index Annualized risk and returns of the asset classes Annualized returns, 1-1-00 to 12-31-14 Return (%) Standard deviation (%) Sharpe ratio Aggregate Index 5.70 3.50 1.09 High Yield Index 7.48 10.02 0.56 S&P 500 Index 4.24 15.26 0.15 Sources: Barclays and Bloomberg L.P. Past performance is no guarantee of future results. Additionally, the Sharpe ratios strongly demonstrate the differences in the return-torisk profiles of the asset classes since 2000. The core bond space (Aggregate Index) has demonstrated a much more constrained level of risk and a significantly higher Sharpe ratio than high yield and equities (S&P 500 Index). These return figures will certainly evolve over time as we put the financial crisis of 2008 further behind us; but, nonetheless, it is an important distinction to note the significant differences in risk (standard deviation) between the investment-grade (Aggregate Index) and belowinvestment-grade (High Yield Index) asset classes. 4

Participants need to be aware of taking on unintended risks Participants searching for asset-class diversification from their equity allocations may inadvertently take on high-yield risks without intending to do so. An investor may be drawn to the intermediate-term bond category to dampen portfolio volatility, seeking a traditional core fixed-income allocation, not a high-yield strategy. But, ironically, a core-plus strategy may act more like high yield than anticipated. Table 3 shows correlations with high yield by asset class. Notice that the core-plus composite has a high positive correlation (0.70) more similar to the correlation of equities (0.72) than to the correlation figures of the Aggregate Index (0.13) and the UST Index (-0.40). a core-plus strategy may act more like high yield than anticipated. Table 3 Core-plus and the S&P 500 Index have similar high correlations to high yield Correlations with the Barclays U.S. Corporate High Yield Bond Index 12-month rolling returns (%), 1-1-00 to 12-31-14 UST Index -0.40 Aggregate Index 0.13 Wells Fargo Advantage Core Bond Fund (Inst Class) 0.32 Core-plus composite 1 0.70 S&P 500 Index 0.72 Sources: Barclays; Wells Fargo Funds Management, LLC; and Bloomberg L.P. Past performance is no guarantee of future results. Securities issued by the U.S. government are guaranteed as to the timely payment of principal and interest. 5

Consider a core bond fund with less volatility and less equity correlation than the core-plus composite One way to avoid core-plus volatility is to consider a core bond fund that seeks to minimize noncore exposure, such as the Wells Fargo Advantage Core Bond Fund. The high correlation of high yield with equities can be even more intuitively understood through a visual presentation of just how closely high yield tracks with equities over time, contrasted against the Aggregate Index (Chart 2). After looking at this chart, it s not difficult to imagine where the stark differences in correlation figures come from recall that the High Yield Index had a correlation of 0.72 with the S&P 500 Index while the Aggregate Index had a correlation of -0.36 with the S&P 500 Index. Indeed, the Aggregate Index shows a far more constrained range of volatility while high yield more closely resembles the amplified volatility of the equities markets. Chart 2 High-yield bonds have tracked with equities 80 60 High Yield Index S&P 500 Index Aggregate Index Rolling 12-month returns (%) 40 20 0-20 -40-60 2000 2002 2004 2006 2008 2010 2012 2014 Sources: Barclays and Bloomberg L.P. Past performance is no guarantee of future results. In similar fashion, the rolling excess returns from the core-plus composite show more resemblance to the patterns of the high-yield and equities markets (Chart 3) than to the patterns of the core bond market. One way to avoid core-plus volatility is to consider a core bond fund that seeks to minimize noncore exposure, such as the Wells Fargo Advantage Core Bond Fund. Volatility was more amplified in the core-plus composite compared with the Core Bond Fund, and core-plus appeared to ebb and flow along with credit events that occur in the high-yield market. By comparison, the rolling excess returns from the Core Bond Fund were smoother and less volatile. 6

Chart 3 Core-plus volatility resembles high-yield volatility Rolling 12-month excess returns over the Aggregate Index (%) 15 10 5 0-5 -10 Core-plus composite (left axis) Wells Fargo Advantage Core Bond Fund (left axis) High Yield Index (right axis) 60 40 20 0-20 Rolling 12-month excess returns over the Aggregate Index (%) -15 2000 2002 2004 2006 2008 2010 2012 2014-40 Sources: Barclays and Bloomberg L.P. Past performance is no guarantee of future results. Conclusion Core bond strategies remain an important foundation of a participant s fixed-income allocation. However, it has become increasingly important to be able to distinguish true core bond funds from noncore and core-plus strategies that may invest in securities with different volatility and diversification characteristics than an investor intends to take on. Participants seeking true exposure to the core bond asset class should not inadvertently select a strategy that deviates from those style-pure characteristics. Most notably, as shown throughout this paper, it s important to appreciate that, as credit quality decreases, those diversification benefits of investment-grade core bonds may diminish. Additionally, the volatility-dampening effect of core bonds to equities also may decline with greater exposure to high yield. participants should constantly be on the lookout for style drift and always know what they are investing in. In short, if your intention is to provide retirement plan participants access to a core bond fund that has limited exposure to high yield, you need a strategy that stays true to its style of investing in the core bond universe. We believe that the Wells Fargo Advantage Core Bond Fund provides the characteristics 2 of a core bond strategy without unduly drifting into allocations of riskier, below-investment-grade securities to enhance total returns. 2. The Wells Fargo Advantage Core Bond Fund is permitted to invest up to 5% of its assets in non-investment-grade debt but maintains a primary objective of investing in core bonds and maintaining low tracking error with the Barclays U.S. Aggregate Bond Index. 7

Appendix A Annualized returns (%), as of 12-31-14 1 year 5 year 10 year Wells Fargo Advantage Core Bond Fund (Inst Class) 6.17 5.30 5.43 Core-plus composite 5.87 5.81 4.97 Figures quoted represent past performance, which is no guarantee of future results. Investment return, principal value, and yields of an investment will fluctuate so that an investor s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted and assumes the reinvestment of dividends and capital gains. Current month-end performance is available at the fund s website, wellsfargoadvantagefunds.com. Institutional Class shares are sold without a front-end sales charge or contingent deferred sales charge. The advisor has committed to certain fee waivers and/or expense reimbursements. Without these reductions, the fund s returns would have been lower. These reductions may be discontinued. Performance for the fund shown reflects a predecessor fund s performance and may be adjusted to reflect the fund s expenses as applicable. Predecessor fund information can be found in each fund s prospectus. For additional information or literature: Call: 1-800-368-1820 Email: wfaf@wellsfargo.com Write: Wells Fargo Advantage Funds P.O. Box 8266 Boston, MA 02266-8266 Visit: wellsfargoadvantagefunds.com The views expressed and any forward-looking statements are as of 12-31-14 and are those of Wells Fargo Funds Management, LLC. Discussions of individual securities, or the markets generally, or any Wells Fargo Advantage Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements. Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held by the fund. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest-rate changes and their impact on the fund and its share price can be sudden and unpredictable. The use of derivatives may reduce returns and/or increase volatility. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk and mortgage- and asset-backed securities risk. Consult the fund s prospectus for additional information on these and other risks. Carefully consider a fund s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, call your investment professional or visit wellsfargoadvantagefunds.com. Read it carefully before investing. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Advantage Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the funds. The funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA/SIPC, an affiliate of Wells Fargo & Company. 230382 02-15 2015 Wells Fargo Funds Management, LLC. All rights reserved. FAPOS16 02-15