Bonds had a very good month with interest rates declining meaningfully across the yield curve, particularly at the longer end. This resulted in a further flattening of the yield curve and the longer bonds outperforming the shorter bonds. The benchmark All Bond Index (ALBI) returned 2.17%, the 12+ area (the best performer) 3.51%, the 7-12 year area 3.04% and the 3- 7 year area 1.73%. The worst performer was the 1-3 year area, returning 0.77%. The money market portion of the benchmark, as represented by the STeFI composite index returned 0.59%.
While a few negatives did emerge for the bond market, these were overshadowed by a number of fairly significant positive events. The negatives were a continuation of the rise in the Brent crude oil price to US$48.92 and a continuation of the very high money supply and credit extension numbers. Also, the Reserve Bank left the Repo rate unchanged.
The major positive for the bond market remained the ongoing rand strength (from R$6.48 to R$6.14). A major driver of the rand strength was the positive ratings watch announcements on South Africa's credit rating from both Moody's and Fitch. The rand strength continued its positive impact on the inflation numbers. Both CPIX and PPI again surprised the market positively. CPIX came out at 3.7% and PPI at 1.4%. While the oil price has been seen as a negative for inflation, it is also seen as a threat to global growth with positive consequences for US bonds. The US 10 year bond declined to 4.06%. The result of these factors is that the benchmark R153 (2010) government bond declined to 8.52% and the shorter R152 (2006) government bond to 7.445%.
The corporate bond market was fairly quiet, with the only new issue being the securitisation of R800 million primary mortgages over a range of commercial properties by Pangbourne and iFour. While a range of notes was issued, they were all floating rate notes.
After an earlier expectation of another Repo rate cut, money market rates increased when it did not materialize. The 12-month NCD rate increased to 7.60% and the 3-month NCD rate to 7.35%.
The bond exposure remained largely unchanged and we invested in medium-dated money market instruments.
The longer the rand remains at current levels the better the inflation outlook, and this will drive the future direction of bond rates. Our base case, however, is still premised on a deteriorating inflation outcome on the back of a strongly growing economy. This should, over time, result in higher interest rate levels. We therefore remained out of the longer end of the bond market.

This quarter saw a reversal of what we had seen over the previous six months. Interest rates across the yield curve declined and a flattening of the yield curve took place. As a result of this the benchmark All Bond Index (ALBI) had a very good return of 6.90%. The best performer of the yield curve was the long end. The 12+ area returned 9.31%, the 7-12 year area 7.73% and the 3-7 year area 6.51%. The short end 1-3 year area, the worst performer, returned 4.22% and the cash portion of the benchmark (as represented by the STeFI composite index) 1.95%. While consumer inflation trended higher over the first half of this year, it fell back sharply in July and August on base effects and lower petrol prices. This was further supported by the continued rand strength and subdued food prices. CPIX fell to its lowest reading on record at 3.7% in August. This was sufficient for the Reserve Bank's Monetary Policy Committee (MPC) to surprise the market by reducing the repo rate to 7.5%. A deteriorating factor has been the oil price with Brent spot increasing to US$46.22 per barrel.
These events brought down the R153 (2010) benchmark government bond rate to 8.81%. Similarly, the R152 (2006) bond rate declined to 7.56%. Over that period we had the United States 10-year government bond rate declining to 4.12%, lending further support to our market.
The corporate bond market was fairly active with the issuance of R1bn A- rated African Bank bonds and R1.5bn AA- rated Barloworld bonds. The only other issue was R0.1bn A+ rated Inca subordinated bonds.
Money market rates reacted very sharply to the surprise repo rate cut. The 12-month NCD rate declined to 7.50% and the 3-month NCD rate to 7.15%. With the strength in the market we increased exposure to some shorter dated bonds. As a consequence we now have an exposure of 45% to the bond market and 55% to the money market.
We believe that any further cuts in the Repo rate unlikely in the months ahead. The rate cut in August has probably hastened the timing of the first rise in the interest rate cycle. As a result, it is likely that the market will start anticipating these rises, which will be negative for the bond market. We are therefore likely to retain the fund's shorter duration position.

The bond market performed very well as a result of interest rates declining meaningfully across the yield curve. Even though the yield curve steepened fairly dramatically, the magnitude of the move was such that the longer dated bonds performed best. The benchmark All Bond Index (ALBI) returned 3.51%, the 12+ area (best performer) 3.99%, the 7-12 year area 3.84%, the 3-7 year area 3.54% and the 1-3 year area 2.02%. The money market portion of the benchmark, as represented by the STeFI composite index, returned 0.68%.
The major event was the surprise 0.50% Repo rate reduction by the Reserve Bank. This came on the back of a rand that has surprised analysts by its persistent strength, which resulted in inflation being a lot more muted than expected. The July CPIx inflation number came out at 4.2% - slightly lower than the expected 4.3%, and down from the previous level of 5.0%. PPI came out at 0.7%, also lower than the expected 1.3%. The rand fell sharply on the back of the Repo rate cut - from R$6.27 to R$6.64. The bond market rallied aggressively on the news, with the R153 (2010) declining from 9.58% to 8.80%. The shorter date R152 (2006) declined even more meaningfully from 8.56% to 7.56%.
The corporate bond market was quiet over the month with no new borrowers coming to the market.
Money market rates declined sharply on the back of the Repo rate cut, with the 12-month NCD rate declining from 8.55% to 7.75% and the 3- month NCD rate from 8.00% to 7.30%.
With the strength in the market we were concerned with our low bond market exposure and increased our exposure to the 3-7 year area of the yield curve. We also invested in longer dated money market instruments.
The longer the rand remains at current levels the better the inflation outlook, which will drive the future interest rate direction. With the more relaxed monetary policy stance that the Reserve Bank appears to be taking, there could be scope for another interest rate cut at the next Monetary Policy Committee meeting. Our base case is still premised on a deteriorating inflation outcome, on the back of an economy that is growing pretty strongly, and we therefore remained out of the longer end of the bond market.

Nedcor Retail Investments proposes on the 1 Nov 04 to amalgamate the Nedbank Income Fund with the Nedbank Flexible Income Fund, and will be managed by Adré Smit of African Harvest Fund Managers according to the investment policy of the Nedbank Flexible Income Fund. Adré currently manages both portfolios.

Bonds had a good month with rates across the yield curve declining and steepening further. This resulted in fairly similar returns in all sectors. The benchmark All Bond Index (ALBI) returned 1.98%, the 3-7 year area (best performer) 2.07% and the 1-3 year area (worst performer) 1.52%. The 12+ year area returned 1.97%, the 7-12 year area 1.94% and the money market portion of the benchmark, as represented by the STeFI Composite Index, 0.638%.
The rand remained strong and closed at R/USD6.27. This ongoing strength resulted in inflation, as measured by the CPIX, continuing to surprise on the downside. The June CPIX came out at 5.0%, up from the previous month's 4.4%, but lower than the expected 5.4%. This positive inflation surprise resulted in sharply declining rates. The R153 (2010) declined by 29 basis points to 9.58% and the shorter R152 (2006) by 55.5 basis points 8.58%.
The bond market remained strong notwithstanding higher than expected PPI, money supply and credit extension numbers. Even the oil price, as represented by Brent crude, which rose from USD33.45 to USD39.29, could not dampen the market. Clearly the strong rand has had a major positive impact on inflation expectations.
The corporate bond market was fairly active, with African Bank coming to the market for R1billion at a spread of 215 basis points above its Government benchmark, and Barloworld for R1.5billion at a spread of 112 basis points.
The money market also had a downward bias, with the 12-month NCD rate declining sharply to 8.55%. The 3-month NCD rate remained unchanged at 8.00%.
The portfolio's bond portion duration is much shorter than the benchmark ALBI and we only have an exposure to the 3-7 year area of the yield curve. In the money market portion the fund moved into longer dated assets prior to the decline in those rates towards the month end.
The fund manager's further reduced the funds bond market exposure and are currently 14% exposed to the bond market, and 86% to the money market with a weighted duration of 0.62 years.
The longer the rand remains at current levels the better the outlook for inflation. At the end of the day, this will drive the future direction of interest rates. The fund manager's base case is still premised on a deteriorating inflation outcome on the back of an economy that is growing strongly. In the event that the rand remains at current levels the fund manager's may review the portfolio structure.

The yield curve flattened dramatically in December, after a smaller than expected cut in the Repo rate. Over the quarter the benchmark All Bond index (ALBI) had a total return of 2.8%. The 7-12 year area was the best performing area with a return of 3.7% and the 1-3 year area the worst, with a return of 2.4%. The fund is overweight the 3-7 year area and underweight the 12+ area, with a modified duration shorter than the ALBI benchmark. The cash portion of the benchmark, represented by the STeFI Composite index returned 2.4%.

Interest rate markets have been driven by Reserve Bank actions, and more specifically the market's expectations of their actions. With the Reserve Bank acting more aggressively than expected, the market, and in particular the short end of the market, came down aggressively. During this period the fund had a rapid normalisation of the yield curve.

In contrast, during December, the fund had a substantial flattening of the yield curve. The short end moved up dramatically after the Reserve Bank reduced the Repo rate by only 50 basis points against market expectations of a cut of between 100 and 200 basis points. Over December the R150 (2005) bond rate rose by 82 basis points and the R153 (2010) by 19.5 basis points, while the R186 (2026) declined by 17.5 basis points.

Money market rates responded in a similar fashion. They declined rapidly over the first two months of the quarter and then rose after the disappointment of the smaller than expected Repo rate cut. The 3-month and 12-month NCD rates reached lows of 7.5% and 7.35% respectively, before moving up to 7.95% at the end of December.

The duration of the bond portion of the fund remained shorter than the benchmark ALBI, and overexposed to the 3-7 year area of the yield curve. In the money market portion the fund manager's reduced the term of the assets, and recent maturities have been reinvested in the three to four month area. The fund manager's have also sold the funds longer dated money market instruments. The fund's bond exposure has been reduced and is currently reflecting an exposure of 43% to the bond market, 57% to the money market and a weighted duration of 1.65.

Fundamentals of the interest rate market show signs of a nearing end to the bull market. While the December CPIX and PPI numbers were in line with expectations, they are nearing the bottom of their cycle. Unless the rand continues to strengthen, all indications are that inflation should start trending up over the next three to six months. Money supply and credit growth numbers have been higher than expected, and this should ring a warning bell for the Reserve Bank to be very wary of further cuts to the Repo rate. On the back of the very strong rand, imports grew rapidly and exports declined - putting potential constraints on the Balance of Payments. The fund manager's believe the probability of further interest rate cuts have diminished meaningfully and the fund manager's are likely to continue investing in the shorter end of the yield curve.