During the fall of 2011, we noted that the trade-off in credit markets caused by European sovereign debt fears had pushed yields on short-maturity BB- and B-rated bonds higher and that the potential risk-adjusted income was attractive compared with many alternatives. This assessment proved accurate as the BB-rated and B-rated short-maturity segment of the high-yield market rallied during the first four months of 2012, even outperforming longer-maturity investment-grade corporate bonds.

This performance is a continuation of a longer-term trend in which the short-term high-yield bond segment (as measured by the BofA Merrill Lynch 0-5 Year BB-B U.S. High Yield Constrained Index) has outperformed longer-maturity investment-grade corporate bonds (as measured by the Barclays U.S. Corporate Investment Grade Index) over the last five years on an annualized basis. Despite this trend of outperformance, we believe high-quality short-term high yield bonds, while not as cheap as they were in the fourth quarter of 2011, still offer attractive income and relatively low expected volatility compared with alternative asset classes that investors commonly consider.

Short-term high yield has generated competitive returns with relatively low volatility
Table 1 illustrates that the returns of the short-term high yield index have been competitive with longer-maturity asset classes of both investment-grade and high-yield credit quality with lower volatility than high yield as measured by standard deviation. This is highlighted by the short-term high-yield category’s strong Sharpe ratio, which measures the return provided for the volatility experienced. Investment-grade corporate bonds have been less volatile, but at the cost of a lower return and with much greater exposure to the potential of rising Treasury yields due to a substantially longer duration. High-yield bonds have provided better returns, but at a much higher volatility due to their exposure to lower-quality credit with longer maturities. Notably, short-term high-yield has significantly outperformed high-yield loans on an annualized basis over the last five years and has done so with much less volatility.

Thus, investors in the short-term high-yield space have earned competitive returns compared with investmentgrade and high-yield alternatives in recent years while minimizing volatility, particularly relative to the much more volatile longer-maturity segments of the high-yield market.

Today, with Treasury yields anchored near record lows and likely to stay there given the Federal Reserve Board’s announced intent to keep the federal funds rate low into 2014, the extra yield available in short-term BB-rated and B-rated bonds relative to Treasuries remains generous. For example, as of April 30, 2012, the yield-to-maturity of the BofA Merrill Lynch 0-5 Year BB-B U.S. High Yield Constrained Index was 6.23%, yet this index had a duration of just 2.1 years. By comparison, the yield-to-maturity of the Barclays U.S. Corporate Investment Grade Index was 3.29% with an effective duration of 6.9 years—significantly higher interest-rate risk (measured by effective duration) with 294 basis points (100 basis points equals 1.00%) less of yield compensation than the short-term high-yield index. While high-yield bonds have offered higher potential yield than short-term high yield, they also leave investors exposed to lower credit quality and longer duration than short-term high yield.

Concluding observations
We believe the short-term high-yield market continues to offer compelling risk-adjusted returns for investors. Yields in the short-term high-yield market remain significantly higher than U.S. Treasury yields and much of the investment-grade bond market, but with less exposure to changes in interest rates. Compared with high-yield bonds and loans, the shorter-maturity profile and generally higher credit quality of the short-term high-yield market has helped reduce price adjustments from negative shifts in credit spreads. In our view, investors who are looking for more income than offered in the Treasury and investment-grade markets but who are wanting to minimize duration risk and avoid exposure to the more volatile parts of high yield should consider investing in the short-term high-yield market.

The ratings indicated are from Standard & Poor’s and/or Moody’s Investors Service. Credit-quality ratings: Credit-quality ratings apply to corporate and municipal bond issues. Standard & Poor’s rates the creditworthiness of bonds, ranging from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody’s rates the creditworthiness of bonds, ranging from Aaa (highest) to C (lowest). Ratings Aa to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories.

Standard deviation of return measures the average deviations of a return series from its mean and is often used as a measure of risk.

Sharpe ratio measures the potential reward offered by a mutual fund relative to its risk level. The ratio uses a fund’s standard deviation and its excess return to determine reward per unit of risk. The higher the Sharpe ratio, the better the fund’s historical risk-adjusted performance.

Duration is a measurement of the sensitivity of a bond’s price to changes in Treasury yields. A fund’s duration is the weighted average of duration of the bonds in the portfolio. Duration should be interpreted as the approximate change in a bond’s (or fund’s) price for a 100-basis-point change in Treasury yields.

Yield-to-maturity measures the rate of return anticipated on a bond if it is held until maturity.

Securities issued by the U.S. government are guaranteed as to the timely payment of principal and interest.

The Barclays U.S. Corporate Investment Grade Index is an unmanaged market value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more.

The Barclays U.S. Corporate High Yield Bond Index is an unmanaged, U.S. dollar-denominated, nonconvertible, non-investment-grade debt index. The index consists primarily of corporate bonds rated Ba and below with a minimum outstanding amount of $150 million.

The BofA Merrill Lynch 0-5 Year U.S. High Yield Constrained Index is an unmanaged index composed of U.S. dollar-denominated below-investment-grade corporate debt securities publicly issued in the U.S. domestic market with remaining maturities of less than five years.

The Credit Suisse Leveraged Loan Index includes tradable, senior-secured, U.S. dollar-denominated non-investment-grade loans.

The views expressed and any forward-looking statements are as of 6-1-12 and are those of the fund managers and 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 fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. High-yield securities have a greater risk of default and tend to be more volatile than higher-rated debt securities. 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. Consult the fund’s prospectus for additional information on these and other risks.