In June 2014 two rating agencies downgraded South Africa. Standard & Poor's reduced its foreign currency rating to BBB-, with a stable outlook. Fitch left its rating at BBB but with a negative outlook. What concerns the rating agencies is the failure of the economy to generate meaningful growth, and the political failure to address this issue. The economy grew only 1.9% in 2013 and, as a result of the devastating impact of the platinum strike, did not grow at all in the first six months of 2014. With the ending of the strike, growth should return to the previous rate of 2%. However, the economy is not growing fast enough to ameliorate serious social problems.

During the past year the rand has weakened significantly, both because the domestic economy has been weak, and also because emerging markets in general have been under pressure. Rand depreciation has had an adverse effect on inflation, which was 6.4% over the 12 months to August 2014. Given the weak economy, the Reserve Bank has hesitated to further increase interest rates, despite inflation being significantly above its 6% target. However, it has warned that real interest rates are too low, and that an increase in interest rates is probable.

The bond market has been largely unaffected by these events, because the pricing of South African bonds is mainly determined by international, rather than domestic, considerations. After a major sell-off in emerging market debt and currencies earlier in the year, markets have stabilised. The continuing guidance from the US Federal Reserve that US interest rates will remain close to zero for a long time yet has generated renewed interest in emerging markets as an investment destination. Capital flows into South Africa have resumed. However, current US monetary policy is ultimately unsustainable and we come ever closer to the day when the prevailing unconventional monetary policy will be abandoned. South Africa's economic challenges make it vulnerable to a return to normal interest rates in the US, which may disrupt inward capital flows.

Given these risks, the Fund's portfolio continues to have a duration less than that of its All Bond Index benchmark. However, the steep yield curve does, to some degree, price in these risks and the portfolio includes a significant investment in higher-yielding longer-dated bonds.

Commentary contributed by Sandy McGregor

In June 2014 two rating agencies downgraded South Africa. Standard & Poor's reduced its foreign currency rating to BBB-, with a stable outlook. Fitch left its rating at BBB, but with a negative outlook. What concerns the rating agencies is the failure of the economy to generate meaningful growth, and the political failure to address this issue. The economy grew only 1.9% in 2013 and, as a result of the devastating impact of the platinum strike, contracted at an annual rate of 0.6% in the first quarter of 2014. With the ending of the strike, and provided there are no other disruptive labour disputes, growth should return to the previous rate of 2%. However, the economy is not growing fast enough to ameliorate serious social problems.

During the past year the rand has weakened significantly, both because the domestic economy has been weak and also because emerging markets in general have been under pressure. Rand depreciation has had an adverse effect on inflation, which increased to 6.6% in May 2014. Given the weak economy, the Reserve Bank has hesitated to further increase interest rates, despite inflation being significantly above its 6% target. However, it has warned that real interest rates are too low, and that an increase in interest rates is probable.

The bond market has been largely unaffected by these events, because the pricing of South African bonds is mainly determined by international, rather than domestic, considerations. After a major sell-off in emerging market debt and currencies earlier in the year, markets have stabilised. The continuing guidance from the US Federal Reserve that US interest rates will remain close to zero for a long time yet has generated renewed interest in emerging markets as an investment destination. Capital flows into South Africa have resumed. However, current US monetary policy is ultimately unsustainable and we come ever closer to the day when the prevailing unconventional monetary policy will be abandoned. South Africa's economic challenges make it vulnerable to a return to normal interest rates in the US, which may disrupt inward capital flows.

Given these risks, the Fund's portfolio continues to have a duration less than that of its All Bond Index benchmark. However, the steep yield curve prices in these risks to some degree, and the portfolio includes a significant investment in higher-yielding longer-dated bonds.

Investors are increasingly focusing on when the current regime of zero interest rates in developed countries will end. The timing of the decision to abandon unconventional monetary policy will be guided by the state of the economy. Conditions in the United States and Europe are improving and central banks are openly discussing a return to normality.

In contrast, conditions in emerging markets have deteriorated. Capital inflows have slowed and countries with large current account de!cits, such as South Africa and Turkey, have experienced a signi!cant weakening of their exchange rates. Over the four months to February 2014, foreigners were signi!cant sellers of South African bonds causing yields to rise. The Reserve Bank reacted to the market turmoil and the threat to inflation of the weaker rand by raising rates by 0.5% and has indicated that further rate hikes are probable.

South Africa remains in a state of stagflation, an unhappy combination of slow growth and relatively high inflation. This makes the conduct of monetary policy very dif!cult. Our judgement is that a very steep yield curve does price in these risks. Accordingly, while the Fund's duration remains below its All Bond Index benchmark, it holds a signi!cant position in longdated high-yielding bonds.

Over the past year South African bonds have moved in lockstep with international bond prices. This is not surprising given that foreigners own about 35% of bonds issued by the SA government.

Bond yields have been depressed by central banks in developed countries, which have set shortterm interest rates close to zero, and in the case of the US Federal Reserve and Bank of Japan, have been actively buying bonds to depress long-term yields. It is widely agreed that such policies will not be sustainable in the longer term, and international bond investors are increasingly focusing on the timing of a return to more normal monetary policy. 'More normal' probably means that globally interest rates will rise.

During 2013, along with other emerging markets, South African bonds sold off, partly due to concerns regarding global rates, but also because investment flows into emerging markets declined significantly. South Africa's current account deficit is currently running at more than 6% of GDP, which is depressing the rand. Financial stability in South Africa is dependent on maintaining the confidence of foreign investors. Capital flight would have an adverse impact on interest rates, inflation and the rand.

South Africa is experiencing stagflation - a weak economy and significant inflationary pressures caused by a declining rand. It is difficult to conduct monetary policy in these circumstances. The economy is too weak to raise rates, but inflation too high to allow a cut in rates. So interest rates will remain unchanged until something significant happens.

The yield curve is very steep, which creates some value in longer-dated bonds. However, given current uncertainties, the duration of the Fund remains below that of the All Bond Index benchmark.