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Quarterly report Q2 2017 | All information is as of 6-30-17 unless otherwise indicated. Wells Fargo Municipal Bond Fund General fund information Portfolio characteristics Ticker: WMBIX Portfolio managers: Lyle J. Fitterer, CFA, CPA; Robert J. Miller Subadvisor: Wells Capital Management Inc. Category: Core municipal bond Fund strategy Uses both bottom-up credit research and top-down macroeconomic analysis Seeks to generate excess performance through actively managing the four key elements of total return: duration, yieldcurve positioning, sector and credit allocation, and security selection Uses a relative-value approach based on extensive credit analysis that seeks opportunities from changing market trends and pricing inefficiencies to generate excess returns Key drivers of performance Amid a more hawkish tone from central bankers, U.S. inflation advances were paltry and municipal yields declined. The fund slightly underperformed its benchmark during the second quarter. Credit-quality allocation was the largest contributor to results while duration, yield-curve positioning, sector allocation, and security selection detracted. Average annual total returns (%) as of 6-30-17* 3 month 1.89 Year to date 3.46 1 year -0.28 3 year 3.67 5 year 4.16 10 year 5.34 Since inception (10-23-86) 5.58 Lipper General & Insured Municipal Debt Funds Average 1.89 2.83 -0.94 3.15 3.13 3.93 – Bloomberg Barclays Municipal Bond Index 1.96 3.57 -0.49 3.33 3.26 4.60 – Municipal Bond Fund–Inst *Returns for periods of less than one year are not annualized. Figures quoted represent past performance, which is no guarantee of future results, and do not reflect taxes that a shareholder may pay on a fund. 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, wellsfargofunds.com. Institutional Class shares are sold without a front-end sales charge or contingent deferred sales charge. The fund’s gross expense ratio is 0.46%. The fund’s net expense ratio is 0.46%. The manager has contractually committed, through 10-31-17, to waive fees and/or reimburse expenses to the extent necessary to cap the fund’s total annual fund operating expenses after fee waiver at 0.48% for the Institutional Class. Brokerage commissions, stamp duty fees, interest, taxes, acquired fund fees and expenses (if any), and extraordinary expenses are excluded from the cap. Without these reductions, the fund’s returns would have been lower. After this time, the cap may be increased or the commitment to maintain the cap may be terminated only with the approval of the Board of Trustees. The expense ratio paid by an investor is the net expense ratio or the total annual fund operating expense after fee waivers, as stated in the prospectus. Avg. eff. duration Avg. maturity (yrs.)¹ AMT² 30-day SEC yield Wells Fargo Municipal Bond Fund Bloomberg Barclays Municipal Bond Index 5.43 15.82 6.59% 2.64% 6.30 13.88 1.64% – Credit-quality allocation (%)3 AAA/Aaa AA/Aa A/A BBB/Baa BB/Ba B/B CCC/Caa and below Nonrated A-1/P-1/MIG1 SP-2/MIG2 A-3/MIG3 Cash equivalents 2.5 14.8 29.9 21.3 4.7 2.0 0.6 10.9 9.1 2.8 0.3 1.3 14.2 53.9 24.7 7.2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Sector allocation (%) GO bonds Insured bonds Prerefunded bonds Revenue bonds 21.4 0.0 7.3 70.1 27.6 0.2 7.1 65.1 1. Weighted average time to maturity. 2. Percent of net assets in AMT bonds. 3. The ratings indicated are from Standard & Poor's, Fitch, and/or Moody's Investors Service. The percentages of the fund’s portfolio with the ratings depicted in the chart are calculated based on the total investments of the fund. If a security was rated by all three rating agencies, the median rating was used. If a security was rated by two of three rating agencies, the lower rating was used. If a security was rated by one of the agencies, that rating was used. Due to rounding, percentages may not add up to 100%. The fund's 30-day unsubsidized SEC yield is 2.64%. (See pages 6–7 for important information.) 1 CM202 07-17 Wells Fargo Municipal Bond Fund Quarterly report Q2 2017 Wells Fargo Municipal Bond Fund Strategy and performance attribution (gross of expenses 4 ) Fund positioning Market activity Result Duration We maintained a modestly short, defensive position throughout the quarter. In the first half of the quarter, we used the basis trade (we sold Treasury futures) to reduce duration. We also sold select longer-duration debt into market strength in favor of increasing our exposure to variable-rate demand notes (VRDNs), which have nearly zero duration. Municipal yields declined across the curve during the quarter, with the greatest declines occurring in maturities of six years and longer. Treasury yields also declined but less so than municipal yields, which resulted in richer municipal/Treasury yield ratios across the curve. Negative Yield curve We maintained a barbelled yield-curve positioning. VRDNs, which provide liquidity and a hedge against rising rates; floatingrate notes (FRNs); and short-term fixed-rate paper made up the front end of the barbell and were paired with fixed-rate and zerocoupon debt in the 10- to 25-year segment. An overweight to the belly of the curve helped results but was more than offset by an overweight to the front end of the curve and an underweight to the long end of the curve (greater than 12 years). The municipal curve continued to flatten during the quarter. Most of the flattening occurred inside of 10 years, while the shape of the curve out past 10 years was little changed. In this environment, the front end of the curve (1 to 5 years) returned 0.56%, the belly of the curve (5 to 15 years) returned 2.17%, and the long end of the curve (greater than 15 years) returned 2.62%. Slight negative Sector In general, we continued to overweight revenue and local general obligation (GO) bonds and underweight state GOs and prerefunded bonds. Detractors included overweights to Illinois, Vermont, and the Virgin Islands as well as underweights to the transportation, health care, California, South Carolina, and Texas. Contributors included overweights to Pennsylvania, Michigan, and education as well as underweights to state GOs, prerefunded bonds, Connecticut, and Minnesota. Among the main sectors, prerefunded bonds (given their shorter duration and higher credit quality) and GOs underperformed, while revenue bonds outperformed. The top-performing subsectors included health care, power, and education. Meanwhile, solid waste/resource recovery and state GOs were the bottom performers. The topperforming states included Pennsylvania and Texas, while Illinois and Georgia were the bottom performers. Negative Quality We maintained overweights to A-rated and BBB-rated debt and underweights to AAA-rated and AA-rated paper. In addition, we continued to have out-of-benchmark allocations to high-yield and nonrated credits. During the quarter, we modestly increased the fund’s average credit quality by selling select medium- and lower-quality paper into strength. Medium- and lower-quality credit tiers outperformed as investors continued their search for yield. Within the benchmark, A-rated and BBB-rated credits returned a combined 2.17%, while AAA-rated and AA-rated credits returned a combined 1.86%. Municipal high yield returned 1.99%. Positive Issue selection Issue selection was a detractor from performance. In particular, selection within the education sector (e.g., Vermont Student Assistance Corporation) and the health care sector (e.g., New York Dormitory Authority) weighed on performance, while selection within the leasing sector (e.g., Delaware Valley Regional Finance Authority) and the industrial development revenue/pollution control revenue (IDR/PCR) sector (e.g., Ohio Water Development Authority and Beaver County Industrial Development Authority) buoyed performance. In addition, selection within the state of Illinois weighed on performance. In May, Puerto Rico's federal oversight board filed an unprecedented petition in federal court under Title III to restructure its $73 billion in debt. While Title III contains a number of key provisions that are similar to Chapter 9, a number of its unique provisions have yet to be interpreted by the courts. The state of Illinois has been without a budget since July 1, 2015, and although it did not reach a budget agreement by the end of the quarter, the recent credit rating downgrades (and threats of more) appear to be helping lawmakers find the motivation to reach an agreement. Negative 4. The gross of expenses performance attribution does not reflect the deduction of the fund’s expenses as shown in the prospectus. 2 Wells Fargo Municipal Bond Fund Quarterly report Q2 2017 Wells Fargo Municipal Bond Fund Fixed-income market review Municipal yields declined and the yield curve flattened 4 AAA-rated GO yield curves 3-31-17 6-30-17 Yield (%) 3 Municipal bond yields declined during the quarter, except at the very front end of the curve. As a result, the yield curve flattened. At quarter-end, the difference between 30-year and 2-year municipal yields was 181 basis points (bps; 100 bps equal 1.00%), which is 22 bps flatter than the end of the previous quarter and 60 bps flatter than the 20-year average. For a historical perspective, the yield curve was at its steepest in January 2011 (447 bps) and at its narrowest in February 2007 (46 bps). 2 1 0 0 yr. 5 yr. 10 yr. 15 yr. 20 yr. 25 yr. 30 yr. Municipals appeared rich relative to Treasuries Municipal/Treasury yield ratios 1.1 Municipal yields are rarely the same (100%) or higher than Treasury yields because of their tax advantage. Conversely, ratios below 90% are indicative of more richly valued municipals. Municipals with maturities of less than 12 years are now in rich territory, and these yields are also below their 20-year average relative to Treasuries. Ratio 1.0 0.9 3-31-17 6-30-17 20-year average 0.8 0.7 0.6 0 yr. 5 yr. 10 yr. 15 yr. 20 yr. 25 yr. More than $5 billion in inflows to municipal bond funds combined with a 14% decrease in supply year to date contributed to the strong performance of municipal bonds. 30 yr. Bloomberg Barclays Municipal Bond Index total return, Q2 2017 Municipal sector (%) Municipal bond 1.96 GO bond 1.80 Insured bond 1.70 Prerefunded 0.54 Revenue bond 2.19 Municipal quality (%) AAA 1.73 AA 1.89 A 2.19 BBB 2.09 High yield 1.99 Municipal maturities (%) 1 year 0.26 3 year 0.54 5 year 1.25 10 year 2.35 20 year 2.49 Long bond 2.75 The Bloomberg Barclays Municipal Bond Index returned 1.96% during the second quarter of 2017. Medium-rated municipals continued to outperform higher-rated bonds as investors sought income. High-yield bonds lagged slightly due to their shorter-duration characteristics but returned a healthy 1.99%. As interest rates fell, longer-term bonds had the best returns. Sources: Bloomberg L.P. and Barclays Past performance is no guarantee of future results. 3 Wells Fargo Municipal Bond Fund Quarterly report Q2 2017 Wells Fargo Municipal Bond Fund The economy and monetary policy Signs of reflation in Europe boosted bond yields there 0.6 Inflation trends remained top of mind. In the U.S., the Federal Reserve (Fed) said that recent slowing of inflationary pressures were likely transitory. The Personal Consumption Expenditure Price Index grew 1.4% on a year-over-year basis in May, which was less than the April rate of 1.7%. Within the subcategories, service price inflation rose 2.2%, nondurable goods prices rose only 1.1%, and durable goods prices declined 2.5% (thanks to discounting on new and used autos). Ten-year German government bond yield Yield (%) 0.5 0.4 0.3 0.2 0.1 0.0 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Europe watched for signs of reflation. European Central Bank (ECB) President Mario Draghi said that the ECB removed its easing bias because deflation was no longer a risk and inflation was expected to move higher. The Bank of England held rates steady although three of its eight members voted to increase the target rate as inflation (as measured by the Consumer Price Index) rose 2.9% in May from a year ago. Meanwhile, 10-year German bond yields shot up to 0.47% alongside expectations for greater inflation. Job openings hit a series high amid labor market strength 7 Nonfarm job openings The job market continued to improve. Unemployment declined to 4.3% in May 2017 from 10% in October 2009, and underemployment fell to 8.4% in May 2017 from 17.1% in April 2010. Both these measures represented cyclical lows. Meanwhile, the number of job openings reached a series high of 6 million in April. This could indicate a mismatch between the job seeker skills and job requirements. While the labor force participation rate has stabilized slightly below 63%, the number of people working part-time for economic reasons (also known as involuntary part-time workers) and the number of long-term unemployed people is higher than during past expansions. Millions 6 5 4 3 2 The Fed continued on its path of gradual rate hikes 1.25 Federal funds target rate (midpoint of range) Percent 1.00 0.75 0.50 0.25 0.00 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Believing the economy is near full employment and inflation will soon reach a long-term target level of 2%, the Fed again raised its target federal funds rate in June by 0.25% to a range between 1.00% and 1.25%. This marks the fourth hike since December 2015. According to the June 2017 Summary of Economic Projections, Fed policymakers expect that a target federal funds rate of 3% would be appropriate over the longer run. Meanwhile, the Fed continued to reinvest proceeds from its holdings of mortgage-backed securities and Treasuries. However, both the March and June Federal Open Market Committee meeting minutes discussed plans to begin gradually slowing reinvestments, thereby shrinking its balance sheet, later this year. Sources: Bloomberg L.P., U.S. Bureau of Labor Statistics, and the Federal Reserve Past performance is no guarantee of future results. 4 Wells Fargo Municipal Bond Fund Quarterly report Q2 2017 Wells Fargo Municipal Bond Fund Portfolio positioning Outlook We remain cautious about interest-rate risk over the longer run because we expect rates will move modestly higher. We may, however, tactically lengthen in anticipation of seasonal effects or trading opportunities. The fund has a barbell allocation to the yield curve. The front end is invested in VRDNs, which provide liquidity and a hedge against rising rates, and FRNs. The longer end is invested in bonds that we expect will benefit from rolling down the steeper parts of the yield curve. We are maintaining our long-term bias toward medium-quality credits because we think the economy will continue to grow and therefore credit conditions may improve modestly. However, we have been tactically increasing the fund’s average credit quality due to the richness of credit in the current environment and are adding medium- and lower-quality credits only on a selective basis. The fund’s allocations to the main sectors remain overweight revenue bonds and underweight both GOs and prerefunded bonds. At the subsector level, the fund is overweight education, IDR/PCR, leasing, special tax, and local GOs. The fund is underweight state GOs, transportation, health care, and power. The fund has very little exposure to Puerto Rico or tobacco bonds, both of which are mostly in the high-yield index rather than the fund’s benchmark. Going forward, we believe the U.S. economy may continue to grow at a modest pace, which should generally lead to higher revenues for many municipalities and improving credit fundamentals. With regard to interest rates, it appears the Fed will most likely raise rates one or two additional times in 2017, which should lead to modestly higher yields. At this juncture, however, municipal yields have declined relative to Treasury yields and outperformed. In fact, municipal yield versus Treasury yield ratios have moved back to a range more typical prior to the financial crisis of 2008. Municipals have outperformed Treasury bills, w ith ratios reaching precrisis levels 1.3 1.2 Ten-year municipal/Treasury yield ratio Ratio 1.1 1.0 0.9 0.8 0.7 0.6 For municipal investors, new policies regarding tax reform and infrastructure spending were not forthcoming. If tax reform becomes a focus of federal policymakers, we encourage investors to look beyond any near-term volatility caused by it. The long-term drivers of valuations will be supply/demand trends, absolute yield levels, the shape of the yield curve, and credit fundamentals. In terms of our sector strategies, the hospital sector has performed well in 2017 but diligence is still required as the specifics of Affordable Care Act reforms may shape reimbursements and financial performance in the sector. Also within the revenue sector, airports, toll roads, and water/sewer bonds remain well bid but therefore have a smaller buffer should spreads widen. The power sector is in transition as cheap natural gas and the onboarding of subsidized renewables puts pressure on other types of electricalgeneration assets. Regarding Illinois, we continue to believe that diverse and informed exposures to securities from within Illinois offer compelling valuations. In fact, securities in the midst of ratings transitions and where investor opinions about them vary have historically been worth close examination for investment opportunities. As of quarter-end, Illinois had not reached a budget agreement. Our expectation at this point is that a downgrade would lead to spread widening as forced sellers or concerned investors exit but investors who believe the problem is more political than economic would invest at recent excessive spreads. Should the political impasse end sooner, particularly with a return to higher income tax rates, Illinois likely will continue to trade at elevated levels given its underfunded pensions, outstanding payables, and budgetary weaknesses, but its spreads could tighten materially. Puerto Rico, on the other hand, remains an extremely risky investment proposition. The recent decision to include the electric utility (PREPA) in the commonwealth’s bankruptcy underscores how unilateral decisions by the oversight board can be both difficult to forecast and costly to the financial outcomes for bondholders. Source: Bloomberg L.P. Past performance is no guarantee of future results. 5 Wells Fargo Municipal Bond Fund Quarterly report Q2 2017 Wells Fargo Municipal Bond Fund Portfolio characteristics: Portfolio characteristics and allocations are subject to change and may have changed since the date specified. Fund facts Inception date Net expense ratio—Inst Assets—all share classes 10-23-86 0.46% $2,648.62M Benchmark descriptions: The Bloomberg Barclays Municipal Bond Index is an unmanaged index composed of long-term tax-exempt bonds with a minimum credit rating of Baa. You cannot invest directly in an index. The Lipper averages are compiled by Lipper, Inc., an independent mutual fund research and rating service. Each Lipper average represents a universe of funds that are similar in investment objective. You cannot invest directly in a Lipper average. The Personal Consumption Expenditures (PCE) Index is the primary measure of consumer spending on goods and services in the U.S. economy. It accounts for about two-thirds of domestic final spending and is part of the personal income report issued by the Bureau of Economic Analysis of the Department of Commerce. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. You cannot invest directly in an index. Rankings and ratings Morningstar total return rankings—Institutional Class (as of 6-30-17) Morningstar Category: Muni national long 1 year 11 out of 158 funds 3 year 45 out of 142 funds 5 year 12 out of 132 funds 10 year NA Overall Morningstar Rating™ The Overall Morningstar Rating, a weighted average of the 3-, 5-, and 10-year (if applicable) ratings, is out of 142 funds in the muni national long category, based on risk-adjusted returns as of 6-30-17. Share class availability Share class Ticker Gross expense ratio (%) Net expense ratio (%) Contractual expense waiver date A WMFAX 0.79 0.75 10-31-17 C WMFCX 1.54 1.50 10-31-17 Admin WMFDX 0.73 0.60 10-31-17 Inst WMBIX 0.46 0.46 10-31-17 The manager has contractually committed to waive fees and/or reimburse expenses to the extent necessary to cap the fund’s total annual fund operating expenses after fee waiver at 0.75% (A), 1.50 (C), 0.60 (Admin), and 0.48 (I). Brokerage commissions, stamp duty fees, interest, taxes, acquired fund fees and expenses (if any), and extraordinary expenses are excluded from the cap. Without these reductions, the fund’s returns would have been lower. After this time, the cap may be increased or the commitment to maintain the cap may be terminated only with the approval of the Board of Trustees. The expense ratio paid by an investor is the net expense ratio or the total annual fund operating expense after fee waivers, as stated in the prospectus. 6 Definition of terms: 30-day SEC yield: The 30-day SEC yield is calculated with a standardized formula mandated by the SEC. The formula is based on maximum offering price per share and includes the effect of any fee waivers. Without waivers, yields would be reduced. The 30-day unsubsidized SEC yield does not reflect waivers in effect. A fund's actual distribution rate will differ from the SEC yield, and any income distributions from the fund may be higher or lower than the SEC yield. Average maturity: The average maturity represents the weighted average time to maturity of all the debt securities held in the portfolio. A relatively short average maturity results in smaller price fluctuations in response to changes in market rates of interest. A short average maturity subjects the owner of a debt portfolio to the risk that maturing debt will be replaced with debt carrying a lower interest rate. Average maturity is an important consideration for investors who hold bond and money market funds. Credit-quality ratings: Credit-quality ratings apply to underlying holdings of the fund and not the fund itself. Standard & Poor's and Fitch rate the creditworthiness of bonds from AAA (highest) to D (lowest). Standard & Poor's rates the creditworthiness of short-term notes from SP-1 (highest) to SP-3 (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 from Aaa (highest) to CC (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. Moody’s rates the creditworthiness of short-term U.S. tax-exempt municipal securities from MIG-1/VMIG-1 (highest) to SG (lowest). Credit quality and credit-quality ratings are subject to change. Duration: Duration is the weighted average of the timing of cash-flow payments from fixedincome securities. Duration is used as a measurement of sensitivity to interest rates. Yield curve: The yield curve is a graphical representation of fixed-income security yields (usually U.S. Treasuries) at their respective maturities, starting with the shortest time to maturity and sequentially plotting in a line chart to the longest maturity. Wells Fargo Municipal Bond Fund Quarterly report Q2 2017 Wells Fargo Municipal Bond Fund The inception date of the Institutional Class was 3-31-08. Performance shown prior to the inception of the Institutional Class reflects the performance of the Investor Class, which incepted on 10-26-86, and includes expenses that are not applicable to and are higher than those of the Institutional Class. The views expressed in this document are as of 6-30-17 and are those of the portfolio manager(s). 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 Fund. Any specific securities discussed may or may not be current or future holdings of the fund. The securities discussed should not be considered recommendations to purchase or sell a particular security. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements. For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar risk-adjusted return measure that accounts for variation in a fund’s monthly performance (including the effects of sales charges, loads, and redemption fees, unless otherwise indicated), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and is rated separately, which may cause slight variations in the distribution percentages.) Across U.S.domiciled muni national long funds, the Municipal Bond Fund received 3 stars among 142 funds, 4 stars among 132 funds, and 5 stars among 106 funds for the 3-, 5-, and 10-year periods, respectively. Morningstar Ratings and Rankings are for the Institutional Class only; other classes may have different performance characteristics. The Morningstar Return ranking is based on the fund’s total return rank relative to all funds that have the same category for the same time period. Past performance is no guarantee of future results. 7 Risks: 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 high-yield securities risk and municipal securities risk. Consult the fund's prospectus for additional information on these and other risks. A portion of the fund's income may be subject to federal, state, and/or local income taxes or the Alternative Minimum Tax (AMT). Any capital gains distributions may be taxable. 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, visit wellsfargofunds.com. Read it carefully before investing. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo 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, an affiliate of Wells Fargo & Company. Neither Wells Fargo Funds Management nor Wells Fargo Funds Distributor has fund customer accounts/assets, and neither provides investment advice/recommendations or acts as an investment advice fiduciary to any investor. 304118 07-17 CM202 07-17 Wells Fargo Municipal Bond Fund