The bond market started the quarter on a bullish note based on benign inflation expectations and investors expecting further repo rate reductions from the South African Reserve Bank. We saw a bond sell off during the quarter which resulted in disappointing bond market performance. The Coronation Income Fund's benchmark, the 1 - 3 year index, returned 1.23% and the All Bond Index 1.10% for the quarter. The R153, a five-year bond, ended the quarter higher at 7.86% after rallying to lows of 7.36%.

Bonds reversed their gains in response to the higher oil prices seen in late August which were exacerbated by devastating Hurricane Katrina which damaged US oil supplies and refineries. Despite a strong rand, the effect of a higher dollar oil price to our economy became apparent and inflation expectations rose. Short-term interest rate sentiment had by quarter-end turned more bearish in response to this. The market is now pricing in a June 2006 repo rate hike for the first time.

Inflation-linked bonds continued to perform well, returning 4.79% for the quarter. Our 11.01% holding contributed to the fund's strong performance.

Although the corporate credit market continued to perform well, the phenomenal demand for these instruments seems to be slowing. The credit spread compression, where the additional yield received over and above that available for an equivalent duration RSA bond, has been slower than the previous quarter, resulting in lower capital gains.

The Coronation Income Fund took the opportunity to reduce its exposure to corporate bonds, to 5.2%. We continue to believe that credit spreads in general are now too tight and do not provide adequate compensation for the risk being taken in many cases. During the quarter the fund purchased the Liberty bond. Subsequent to its inclusion, the Liberty bond has had capital gain with the 10 basis point credit spread compression. We continue to monitor the credit quality of the portfolio and adjust our exposures accordingly.

Twelve-month money market rates headed higher this quarter and are now yielding 7.30%. The two-year money market rate is now pricing in a 1% repo rate hike.

Domestic macroeconomic data for August (released in September) showed that inflation is rising. Inflation at the consumer (CPIX 4.8%) and producer (PPI 4.2%) levels were largely in line with expectations but higher than we have seen in recent months. Most analysts for the first time are conceding that there is no longer a chance of further interest rate easing given these numbers and that indeed the first repo rate hikes are visible on the horizon.

Our short duration bond strategy combined with a healthy exposure to corporate and inflation-linked bonds has been the winning formula so far this year. The Coronation Income Fund's relative ranking has soared with recent figures placing it at number 1 year to date and number 2 for the quarter and last six months.

Bonds remain overvalued, but with the sell-off seen recently the market is approaching fair value. We remain short duration until such time as they become cheaper. We will then start to buy them back selectively. We are pleased to have delivered a 1.66% return for the quarter and 8.16% year to date, beating the 0 - 3 year bond index over both measurement periods.

Tania Miglietta
Portfolio Manager

Fixed interest market participants were once again taken by surprise this quarter at the South African Reserve Bank's announcement of a further 0.5% reduction in short-term interest rates (the repo rate) in April, taking it to a new low of 7%. With bank NCD rates at between 6.85% - 7.10%, SA short-term interest rates are at all time lows. The MPC left the repo rate unchanged in June.
SA bonds (ALBI) returned 5.29% for the second quarter after a series of volatile monthly returns: a strong June figure (2.69%) followed a poor figure in May (-0.12%), after a good April (2.06%). Recent strong performance was due to higher demand for local bonds (from foreigners) together with falling 10-year US Treasury yields. The US Treasury remained low, as inflation concerns from higher oil prices seem to be subsiding, and economic indicators are implying a slowing US economy going forward.
Corporate bonds have done well, returning 5.31% for the quarter. This was aided by spread compression, where the additional yield received over and above that available for an equivalent duration RSA bond, is reduced, due to re-pricing from high demand. The Coronation Income Fund has 23% in corporate bonds, holding those which we believe continue to offer us value. We believe that credit spreads in general are too tight and do not provide adequate compensation for the risk being taken in many cases.
The star performing interest rate assets for the month were inflation-linked bonds. The inflation-linked index returned 6.97% for the quarter, outperforming all other fixed interest asset classes. Strong demand with limited supply at the bond auctions has lead to aggressive bidding for inflation-linked bonds. Their yields, expressed as a real yield, fell by more than 30 basis points on average, resulting in a healthy capital gain to investors. The Coronation Income Fund holds 10.6% in inflation-linked bonds and will have benefited from these moves.
The SA FRA (Forward Rate Agreement) curve, which gives us an idea of what the market in general expects of the repo rate has been persistently pricing in a 50% chance of a further 0.5% repo rate cut over the next few months despite a weaker currency this year. Historically it has tracked the rand/dollar closely but appears to have decoupled from this for now, as it is no longer pricing in a flat interest rate scenario for the medium term, which it would if it continued to follow the weaker exchange rate.
Domestic economic releases for May showed that on many fronts the domestic economy is still powering ahead. Inflation, both at the consumer (CPIX 3.9%) and producer (PPI 2.4%) level is rising (with PPI having surprised on the upside). M3 money supply and credit extended were very strong figures proving that both the consumer and corporates continue to borrow and spend. Most analysts for the first time are conceding that there is a diminishing chance of further interest rate easing given these numbers.
Our short duration strategy still holds. We believe that bonds remain overvalued at these levels and that we will see better buying opportunities over the next few months (although these may be kept lower by foreign investor appetite).
The Coronation Income Fund continues to be conservatively managed. We are pleased to have delivered a 2.53% return for the quarter and 4.16% year to date, beating the 0 - 3 year bond index (3.63%), for the year to date. A survey compiled by Prescient Securities shows that we are the number one ranked income fund year to date.

The Coronation Income Fund is made up of carefully selected bond and money market assets which are chosen for their high running yield, their liquidity and their likelihood of outperforming the benchmark (1-3 year Bond Index) over time. During the last quarter, we have been very conservatively positioned with a short modified duration as our expectations were for bonds to sell-off, taking with it any unrealised capital gains. We therefore have concentrated on investing in low-duration investments, such as cash, floating rate and inflationlinked structured notes, high yielding corporate bonds and securitisation. This has ensured that we deliver the highest available yield, whilst still minimising capital losses.
The money market began the year on astounding bullish sentiment! Pressure existed in the market for short-term interest rates to move lower, given a persistently strong rand, the strength in the bond market and money market derivatives pricing in the next repo rate cut. This was a concern, as we believe that another interest rate cut would further fuel an already aggressive consumer spending pattern and only exacerbate inflation going forward.
By February we were pleased to note that the South African Reserve Bank (SARB) had agreed that no further reduction in interest rates was necessary and the repo rate remained at 7.50%. Money market rates have since started to edge higher as the market starts to recognise that the cycle may be turning and the very low interest rates of the past 18 months are likely to increase. The market is now pricing in a good chance of the first 50 basis points repo rate hike taking place in April 2006.
Jibar rates (Johannesburg Interbank Average) have risen recently, indicating to us that South African banks no longer expect further rate reductions. The sharp downward move in interest rates over the last six years is visible in the chart below. The interest rate cycle may well start to turn during the course of this year.
South African bonds had their worst month in over three years during March, losing 3.67% in one month alone and underperforming all other domestic asset classes. Coronation Income Fund has weathered this storm by being short duration for the full quarter. It returned 1.59% for the first three months of the year, versus the 1-3 year Bond Index which returned 0.24% - this is substantial outperformance.
The Coronation Income Fund has resumed its outperformance of the 1-3 year Bond Index over the shorter term after having been short duration during the surprise bond rally of the latter part of last year.
The fund continues to invest in liquid money market assets and suitable short to medium-dated bonds which are selected for their value relative to Coronation's interest rate view. This quarter we bought into a series of floating structured money market assets which have performed in the sell-off we expected from the bond market.
Going forward we expect an ongoing sell-off in the bond market (we have just seen the beginning of this), and a gradual upward move in money market rates will follow. The imbalances in the current account will lead to a weaker rand over time and ultimately push inflation higher. Economic indicators show that the demand side of the economy is strong which should lead to higher prices. For inflation to be kept in check, the repo rate will have to rise.
We expect that by the end of the year, we will have seen the first interest rate hike of 50 basis points, taking the repo rate to 8%. The risk to this view of course is that a rebound to the rand/US dollar exchange rate back to below R/US$6.00 will impact positively on inflation, putting a "cap" on short-term interest rates.

The ongoing debate in the fixed interest market during the final quarter of 2004 was on the direction of interest rates based on the unusual 50/50 split in the expectation for the repo rate at the year-end MPC meeting. The market remained undecided as to whether repo was going down or not, until it was revealed on 09 December 2004 that interest rates were indeed not going to be reduced. In the past, MPC decisions were reasonably clear and predictable. After the surprise August repo rate cut and a persistently appreciating rand/dollar exchange rate, strong arguments supporting both existed and indeed were hotly debated.
On the MPC announcement, the yield curve adjusted pricing out the growing chance of ever lower interest rates. Short-term rates (especially short-term derivatives) during 2004 were highly influenced by the volatile and ever strengthening rand/dollar exchange rate.
The repo rate ended the year at 7.50%, with cash (3- month STeFI Index) returning 7.75% and bonds returning 15.25% for 2004. Bonds turned the corner and outperformed cash for the year despite their wobbly start to the year. Stable, low interest rates contributed to what may be a new paradigm for cash returns in South Africa, whereas double digit figures were the norm in previous years.
The Coronation Income Fund returned 8.52% for 2004. The fund was conservatively positioned in the bond market throughout the year, with a shorter overall duration (and hence lower interest rate risk) than benchmark, given our growing concern for a bond market sell off. Our expectations for rising inflation, higher US Treasury yields and a reversal of the global appetite for risky assets underpins this view. The Coronation Income Fund is mandated to provide a consistent high yield and to avoid capital loss. We therefore remained conservatively positioned as bonds broke through fair value levels, moving into overvalued territory.
The Coronation house view going forward is for the imbalances in the current account to lead to a weaker rand over time which will result in higher inflation. With economic indicators showing that the demand side of the economy is strong with no signs of abating, prices are likely to rise which will ultimately mean the need for a higher repo rate to keep inflation within the target bands of 3% - 6%.
This scenario is likely to unfold in the latter part of 2005/early 2006. The risk to this view of course is that a continuously strong rand will impact positively on inflation, keeping short rates down for longer.