The yields on South African bonds are influenced significantly by foreign investment flows. During September foreigners have been net sellers, driving up the yield on the 10-year bond from 7.6% to 8.4%.

The selloff was precipitated by the European fiscal crisis and a significant slowdown in the fast growing countries of Asia. The political news flow from South Africa may also have had an adverse effect. Capital outflows have caused the rand to weaken. Rising import prices will reinforce inflationary pressures brought about by parastatal tariff hikes and big increases in labour costs. Inflation is likely to be much higher than the targeted 6%. The Reserve Bank has become concerned about stagnant domestic business conditions. Accordingly, the Monetary Policy Committee is likely to delay putting up rates as long as it can. However, the trend in inflation will ultimately require a rise in rates.

These risks are priced into the yield curve, which is very steep. At the end of September the 25-year government bond yield was 9.0% with call money at 5.5%. Investors are now offered some compensation for the risks associated with buying long-dated assets. Therefore while the duration of the Fund is still below its All Bond Index benchmark, we have taken advantage of the recent selloff to buy certain higher yield long-dated bonds. The Fund's assets reflect a conservative attitude to credit risk.

Foreign buying and selling is a significant determinant of prices in the South African bond market. The spread between the benchmark US bond yields and South Africa has in recent years contracted as offshore investors perception of the relative risk of investing in South Africa has improved. For the past three years the South African 10 year government bond has consistently traded at about 5.25 per cent higher than the equivalent US bond. Deflationary pressures have depressed the yield on US and German bonds and SA bonds have followed suit. This benign environment has been underpinned by an appreciating rand and declining inflation.

There is no inevitability that this relationship between South Africa and the rest of the world will be sustained. In particular there are risks that inflation will now surprise on the upside, reflecting extremely rapid growth in domestic wages. The transmission mechanism of excessive wage growth into prices will ultimately take place through the exchange rate. A significant depreciation of the rand will be following by a big rise in domestic prices which would force the SARB to raise interest rates.

To some extent the bond market is pricing in these risks through a very steep yield curve. The managers of your Fund have taken advantage of this to maintain a relatively high yield. However they also have for the past three years reduced risk by maintaining duration significantly below that of the ALBI benchmark.

The Fund's assets reflect a conservative attitude to credit risk, at the end of June 2011. About 72 per cent of the portfolio was in government or government guaranteed issues.

Movements in the local bond market continue to demonstrate the sensitivity of South African bonds to foreign flows. South Africa is reliant on these flows because of a low domestic savings rate and sizeable government borrowing requirement. There are indications that the downward path of inflation of the past two years is being reversed. Short-term interest rates are probably at the bottom of their cycle. Given the combination of these circumstances, we believe a cautious investment stance is appropriate. The Fund's duration remains significantly below that of its All Bond Index benchmark..

Local bonds strengthened over the past few weeks, somewhat breaking with the recent trend of following the movements of international bond markets which have traded in a tight range recently.

The movements in the local bond market in November and December demonstrated the sensitivity of the South African bond market to foreign flows. South Africa is reliant on these foreign flows because of the low domestic savings rate and sizable government borrowing requirements. Accordingly, we believe a cautious investment stance is appropriate. The Fund's duration remains significantly below that of its All Bond Index benchmark.