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Overview, Strategy, and Outlook: as of June 30, 2010

In the closing days of a challenging quarter, U.S. Senate and House conferees put the finishing touches on a mammoth piece of legislation, the "Restoring American Financial Stability Act of 2010." Reportedly tipping the scales at 2,000-plus pages, this bill contains numerous provisions that will revamp the U.S. financial system in ways as yet unimagined. Also referred to as the "Dodd-Frank bill" (perhaps to make it easier to know whom to blame the next time around), the reforms cover the gamut from special oversight of systemically significant firms, an increase in the deposit insurance ceiling, regulation of derivatives contracts, provisions limiting and regulating bank and hedge fund activities, to a new tax on large banks, and much, much more.

Money Market Overview
From the perspective of money market funds, the most closely watched provisions of the bill had to do with repurchase agreements. At one point, creators of the legislation contemplated increasing from one day to three days the time before a repurchase agreement investor could take possession of the underlying collateral in the event of a failure of the repo counterparty. It was speculated that such an increase might mean that repos could not be considered "fully collateralized" under Securities and Exchange Commission (SEC) Rule 2a-7 and would be subject to the same issuer diversification limits as other investments, such as unsecured corporate obligations. With repos comprising over one-third of all investments eligible for purchase by money market funds, this would have put quite a ding in the supply side of the equation. In the end, the period of the stay does not appear to have been increased, and repos remain a safe and eligible investment for money funds. Although the financial reform legislation has essentially been reported as a done deal by the mainstream media, several senators who had supported the Senate version have stated that they will not support the version coming out of the Conference Committee, at least in part due to the last-minute addition of $19 billion in new taxes. This development, along with the death of Sen. Robert Byrd, made passage of the bill in time for the President's planned signing ceremony on July 4 less than certain.

Declining supply has been a problem plaguing the money market for almost three years now, and it's a topic we've written about in some detail in past commentaries. Money market participants are hopeful that we may have hit a bottom in asset-backed commercial paper (ABCP) outstanding, with outstandings in that category increasing in June. After increasing intra-month, total commercial paper outstanding fell during the last week of the month and decreased from $1.054 trillion at the end of May to $1.028 trillion at the end of June. This is well below the lofty levels seen in 2007—and supply in other sectors of the money market remains under pressure—but money market participants were glad for the reprieve in the ABCP sector.

COMMERCIAL PAPER OUTSTANDING ($Billion)
Weekly (Wednesdays), Seasonally Adjusted

Source: Federal Reserve Board

One sector that saw healthy growth in June was puttable bank paper, with more than $16 billion coming to market in the last two weeks of the month. As European banks especially struggled to access the longer-dated funding preferred by their regulators, they began offering securities with final maturities of six or 12 months, but which also allowed money market participants to demand payment with a notice period as short as seven days. Long a staple of the municipal money market, longer-dated issues with seven-day demand features have advantages for both the issuers and market participants. This paper helped facilitate bank access to the U.S. markets that was otherwise limited after the scare around Greece. At the same time, these issues give money market funds the much needed shorter-dated paper that they need to be prepared for potential shareholder withdrawls and to meet the new liquidity requirements imposed by the amendments to SEC Rule 2a-7. Other banks issued paper with longer put notification periods of 30 to 90 days. Although there was significant interest in these issues, we found them less compelling than the issues with seven-day puts.

Credit Landscape
For European banks and sovereigns, the funding environment improved significantly during June. Recall that the triggers for these concerns were the budget deficit in Greece and the attendant worries about how exposed European banks might be to Greek debt. This led to market participants backing away from European banks, either by shortening maturities or by not lending at all. In June, we saw renewed interest in European bank debt. As the European Central Bank (ECB) begins to release the results of its stress-testing scenarios, the banks that have been tested were reported to be in good shape. While the longer-maturity issuance was still largely closed to many of these banks, they were able to issue significant amounts of puttable debt. Hanging over this market was the expiration of the ECB's one-year tender from last year, which necessitated the July 1 repayment of 442 billion euros borrowed by the banks last year. The real test came on June 30, when the ECB conducted its tender for loans for a three-month term. Market participants expected the banks to borrow a significant amount in this unlimited tender in order to raise funds to repay the ECB. Both the amount lent to banks and the number of banks participating were well below market expectations, indicating that these banks are not in the dire straits that many feared. Subsequent to the release of the tender results, share prices rebounded, credit default swap (CDS) spreads narrowed, and the general picture for European banks shifted from gloomy to guarded.

LIBOR YIELD CURVE COMPARISON (%)


Source: Bloomberg LP

There were some rough waters in the industrials sector this month as well. BP's troubles in the Gulf of Mexico were also grabbing headlines this past month. BP tumbled from one of the premier credits in the market to one surrounded by question marks. It was downgraded to BBB/F-3 at Fitch, while BP North America was downgraded to Baa1 at Moody's. All of the major rating agencies have the company ratings on review for further downgrades. Its problems, of course, stem from the massive oil spill in the Gulf. BP has agreed to create a $20 billion claims fund over the next three years, depositing $3 billion in the third quarter and another $2 billion in the fourth quarter. However, this does not put a cap on the company's potential liabilities. The cost to BP as of June 28 was $2.65 billion. Rumors are starting to circulate that ExxonMobil is looking to acquire BP. Beginning July 12, BP management will be subjected to hearings in the affected Gulf Coast states, and the first will be Louisiana. The hearings will allow the impacted residents to voice their concerns. As of the end of June, BP had recovered more than 500,000 barrels of oil using containment systems and had also skimmed over 652,000 equivalent barrels of oily liquid from the sea. The first relief well has reached over 16,000 feet of the 18,000 feet necessary to intercept the original well. The target date to complete the relief well is the beginning of August. BP had net income of $6.2 billion in the first quarter of 2010 and cash exceeding $5 billion. On paper, BP's financial position remains solid, but the political uncertainty caused us, and we believe other money market funds, to remove BP from our approved list of issuers.

RATES FOR SAMPLE OF INVESTMENT INSTRUMENTS (%)
May 2010 and June 2010

Source: Bloomberg LP

Strategies for the Prime Funds
London Interbank Offered Rate (LIBOR) took a breather this month after rising from mid-March to late May. As shown in the rates table on the previous page, one-month, threemonth, and six-month LIBOR were almost unchanged, trading within one basis point (bp) all month from their June closing levels of 0.35%, 0.53%, and 0.75% respectively. Yields on commercial paper (CP) and bank CDs traded at a positive spread to the LIBOR settings at the beginning of the month. Almost all issuers had to pay a premium to LIBOR, since the market was still jittery over bank and sovereign concerns. By the end of June, a certain tiering had become the norm: Spanish, Italian, and Irish banks had to pay about 20 bps over LIBOR to get funded, and French banks about five to 15 bps over LIBOR, while Canadian and Australian banks could get funded at LIBOR less five to 15 bps. ABCP yields settled in at LIBOR plus or minus five bps.

We found value in the floating-rate note issuance of bank paper with a seven-day put feature. Notes that we participated in have rates resetting monthly off one-month LIBOR and are puttable on any business day with payment received in seven days. So far, issuance has the resets also widening over the life of the bond. We have focused our term trades on commercial paper with one- to three-month maturities; this strategy has served us well, as this is the steepest part of the short end of the yield curve.

We continue to hold about 7% of our prime category money market portfolio assets in tax-exempt variable-rate demand notes (VRDNs). Most VRDNs with a daily put option had yields comparable to overnight repo yields, while weekly VRDN yields were comparable to those of one-week commercial paper. This allows us to maintain or increase the interest-rate sensitivity of the funds as rates rise, without locking up yields for longer periods of time.

Our focus remains on liquidity and maintaining a stable $1.00 net asset value (NAV). In our prime category money market funds, we have mostly avoided investing in securities longer than three to four months in maturity. And, as rates have started to rise, we have the liquidity and flexibility in our weighted average maturities (WAMs) to take advantage of some of these offerings. We will continue to do so judiciously. As the trend in rates has now shifted to increasing levels, it could continue for some time before yields get to a normalized level.

YIELD COMPARISON IN THE MONEY MARKET (%)
as of 6-30-10

Source: Bloomberg LP

Strategies for the U.S. Government Funds

Looking at the table above that shows the month-over-month change in yields, one would think it was a relatively calm month in the markets for both U.S. Treasury bills (T-bills) and government-sponsored enterprise (GSE) discount notes. It was anything but. A combination of quarter-end pressures and a roller coaster ride in supply dynamics caused quite a bit of yield volatility during the month.

The month leading up to a quarter-end has become more and more challenging for money market participants looking for suitable investments at relatively attractive yields, and June was no exception. Bank and broker/dealer mandates have been to keep their balance sheets in check by reducing leverage and shrinking the amount of security inventory held on their books. This second point became more prevalent as we neared quarter-end and pressure to clean up balance sheets was more intense. Because of this fact, money market participants, needing to ensure that they leave little uninvested cash in their funds at the end of the month, scrambled to find suitable investments in the weeks leading up to it.

However, at the same time that money market participants were clamoring for securities in the middle of the month, supply of available products decreased. The amount of new T-bills the U.S. Treasury was issuing each week was less than the amount maturing, reducing the availability of that product. While the amount of GSE discount notes available remained fairly constant, market participants, unable to reinvest back into the T-bill market, chose to invest in shortdated discount notes to get over the quarter-end. This demand drove yields on T-bills close to zero and yields on discount notes down to the mid-single digits mid-month.

As the month came to a close and most money market participants had already positioned themselves accordingly, demand dried up and yields rose smartly. Ultimately, yields closed out the month just about where they began. A fun roller coaster ride to say the least.

Our focus in the Wells Fargo Advantage 100% Treasury Money Market Fund has been to ladder maturities across the yield curve in an effort to provide liquidity and maintain a stable $1.00 NAV. In the Wells Fargo Advantage Treasury Plus Money Market Fund, we have emphasized U.S. Treasury-backed repurchase agreements, which offer price stability and daily liquidity at a higher yield than T-bills. The focus in the Wells Fargo Advantage Government Money Market Fund has been on liquidity and a stable $1.00 NAV. Most of our investments have been in GSE-backed repurchase agreements and threeto six-month GSE debt, which is consistent with the primary objectives of the Fund.

Strategies for the Municipal Funds

Municipal money market funds continued to experience a slow bleed in assets as increasing investor nervousness and weak equity markets were not enough to overcome the continued apathy for low absolute money market fund yields. Total municipal money market fund assets dropped almost 2% from $357 billion as of May 28, 2010, to $351 billion as of June 28, 2010.

During the month of June, municipal money market rates remained steady across all maturities, while the overall sector yield curve remained essentially flat. For the third straight month, the Securities Industry and Financial Markets Association (SIFMA) seven-day floater index averaged 0.29%, indicating a steady balance between supply and demand for short-term floating-rate securities. Again, the index reset in an extremely narrow range, bouncing between 0.26% and 0.32% during the month. Municipal commercial paper in the 30- to 90-day range remained anchored at roughly 0.30%.

The arrival of "note season" had very little impact on the municipal money market yield curve, as high-grade benchmark issues, such as Oregon and Idaho tax anticipation notes, were met with strong demand. Overall, yields on longer-dated, fixed-rate money market eligible paper exhibited calm, with Municipal Market Data one-year yields inching up slightly from 0.28% at the end of May to 0.30% at the end of June.

In light of anemic cash flows and a flat yield curve, our investment strategy across all municipal money market funds continues to be principal preservation with an emphasis on maintaining high levels of liquidity. Accordingly, we continue to favor floating-rate and variable-rate demand notes with daily and weekly puts as a means of maintaining liquidity and relatively short weighted average maturities.

The Inside Track

The Federal Reserve remains committed to a zero interestrate strategy as far as the federal funds target rate goes, but other events have contributed to an increase in rates further out on the money market yield curve. There continues to be a disconnect between the issuers' desire to fund longer and market participants' need for shorter-term investments. Although we've seen some securities issued that bridge the gap, demand continues to outstrip supply, and we believe that the yield curve will steepen further. In light of this, and the uncertainty that currently surrounds the money markets, we continue to focus our investment strategy on a stable net asset value and a high degree of portfolio liquidity.

Please note that the Portfolio Manager Commentary will be off for summer vacation next month. We'll return with our usual monthly commentary in early September.

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The views expressed are as of June 30, 2010, and are those of David D. Sylvester, portfolio manager, Money Market Team at Wells Capital Management, subadvisor to the Wells Fargo Advantage Money Market Funds and Wells Fargo Funds Management, LLC. The views are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any Wells Fargo Advantage Fund.