After recording losses in Q2, bonds rebounded somewhat to show a positive performance in Q3. The 1 - 3 year bond index returned 1.6%, just underperforming cash of 1.9%. The All Bond Index returned 2.1% for the quarter, aided by longer-dated bonds which produced better returns than shorter-dated ones.
Bond market performance was perhaps surprising, given that we entered the quarter just following the first interest rate hike for the cycle in June, and ended it amid a volatile and much weaker rand. Even as expectations cemented around further rate rises - and despite a poor performance by the rand - longer dated bond yields generally moved in a sideways range over the quarter.
It was unusual for the longer-dated bond yields to not have responded more negatively, especially with notable rand depreciation. However, a possible explanation may be that in late June after the first repo rate hike, bond yields broke a lot higher and stayed there - pointedly ignoring the currency appreciation seen in July and August. It thus seems feasible that the reason that longer-dated bonds largely ignored the weakening in the rand during September was that they had effectively already discounted it.
It also appears that central bank credibility was established through the 50 basis point rate hikes in June and September. The bond market appears to have confidence that the SARB will respond appropriately to ensure that any inflationary impact of the rand's weakness will be short-lived. With the depreciation in the rand so far this year (it is currently down around 25% on a trade-weighted basis) together with the interest rate rises that we have seen so far with more to come, it is a matter of time before the worrying current account deficit starts to correct.
The international backdrop remains of critical importance too. The rand's reaction to the news of the current account deficit should be seen in the context of jitters in emerging market currencies - especially those of countries with high current account deficits. Furthermore, the restraint in local bond yields, would probably not have been possible had both US Treasury yields and emerging market bond spreads (as measured by the EMBI) not have remained at relatively low levels during the quarter.
Money market rates on the other hand rose to levels of around 9.5% this quarter, which offers good value versus bonds. Hence we continue to invest in the 1 to 2 year area of the curve, largely using tradeable fixed rate NCD's which pay regular interest and are issued by the top four banks.
The Coronation Income Fund's asset allocation has swung towards holding a higher proportion of lower risk money market assets over bonds. The majority of the bond component is represented by a selection of corporate bonds which provide an attractive yield pickup over government bonds. The portfolio ended the quarter with a duration of 1.52 years versus that of the benchmark of 1.4 years.

Tania Miglietta
Portfolio Manager

Bonds extended their losses, with the All-Bond Index (ALBI) down 3.6% for the quarter. This brings the year-to-date loss on the ALBI to just over 2%. The defensive, short-duration position maintained in the Coronation Income Fund against this background proved to be the right move; the benchmark 1 - 3 year bond index declined by 0.28% for the quarter but still managed a positive return for the year to date.
Bonds are the worst-performing asset class so far this year, with their negative performance being trounced by equities: up 4.9% for the quarter, despite the jitters seen in May and June, and still up a smart 18.8% for the year to date. Bonds trailed cash (up 1.8% for the quarter and 3.6% year-to-date) as well as inflation-linked bonds, which were up 0.6% for the quarter and 3.3% for the year so far.
The poor bond performance was led by a number of factors, principally the reduction in risk appetite for emerging market assets that we had expected would eventuate sometime this year. The trigger point seemed to be the US Federal Reserve raising interest rates beyond where many had expected, coupled with expectations of further monetary tightening by both the European Central Bank and the Bank of Japan. Many other central banks, including those of a majority of emerging markets have been in, or have now begun, a tightening mode. Rising interest rates both reduce general liquidity available in the market - usually meaning a fall in risk appetite - and also raise the relative return required by other assets if they are to continue to remain attractive.
Although the JPMorgan Emerging Markets Bond Index (EMBI) has held up quite well, it is weaker than its best levels of earlier in the year. Local bonds were affected by this, but seemingly more so by the fall in the rand that accompanied lower risk appetite. At the time of writing, the trade-weighted rand has lost some 18% since late April. The cherry on top for the bond market was the SA Reserve Bank's (SARB) move to raise the repo rate by 50 basis points to 7.5% at the June Monetary Policy Committee meeting. While the FRA market had discounted some probability of a rate rise, it seemed that the bond market was to a large extent caught unawares by the move. A negative current account number for the first quarter subsequently sent jitters through the market opening the possibility of further rises of the SA repo rate. We have for some time expected that interest rates would enter an upcycle this year and thus were positioned for the market moves.
Given that the weakness in the bond market hadn't yet filtered through to property stocks, we sold down most of our SA property holding. This proved to be the correct move as the property index sold off towards mid-June. We took profits on rand hedge stock Liberty International. which rallied to return over 11% for the quarter
While we are not implementing any material adjustments to our inflation forecast in light of recent developments, some factors have deteriorated more than we had expected and thus upside risks remain. At present we expect SARB to raise interest rates another 100 basis points by February 2007.
While inflation-linked bonds have outperformed conventional bonds over the past year, with real yields starting to rise and breakeven inflation rates up at levels that no longer offer value, we are now selling most of our holding. Looking forward, it seems it will be very difficult for inflation linkers to outperform cash.
An interesting development in the domestic market was a change in sentiment towards credit, where the previous "buy at any price" attitude towards new corporate bond issues received a shock when buyers weren't as prevalent as before. We have for some time believed that credit pricing did not justify the risks and that it made sense to hold only fairly-priced highquality issuer names.
While we had been defensively positioned in the run-up to the repo rate hike, we feel that bond yields are closer to fair value. Still, the call between bonds and cash remains a close one over the next 12 months - especially on a risk-adjusted basis. The process of increasing global interest rates is likely to continue for some time, which will continue to bias sentiment against risky assets. Risks for the rand (and consequently inflation) are also thus probably biased to the negative, both from the global background as well as the wide current account deficit. While bonds are not as overvalued as they were at the beginning of this year, we would remain wary of positive gains for a while, especially until it is clearer where and when the domestic monetary tightening cycle will end.

Tania Miglietta
Portfolio Manager

Last year was an excellent year for the Coronation Income Fund which took top honours at the 2006 Raging Bull Awards for the best risk-adjusted return over three years, and was ranked Best in Sector at the Standard & Poor's Awards for the year to end December 2005.

The Coronation Income Fund has had a good start to the year with the fund returning 1.7% for the first quarter.

In a relatively rare turn of events, the SA bond market produced a negative return in March. The All Bond Index (ALBI) fell by 0.23% over the month, although shorter-dated bonds did produce small positive returns. Over the first quarter, bonds still produced a positive return of 1.5%. Again, the shorter area was the place to be: the 1 - 3 and 3 - 7 year areas each returned 1.8%, but longer bonds produced less.

The ALBI was the worst performer in both March and in the first quarter, being beaten even by cash (+1.7%) and, as has become commonplace, by inflation-linked bonds (+2.7%).

It certainly was not as though any great problem beset South Africa in particular; on the contrary, the bond market took heart from a continued relatively strong rand and contained inflation. Rather, we saw bonds weaken as a spillover from jitters in global markets - something that we have been highlighting as a potential risk for a while.

It seems that March marks the lower turning point in global bond yields too. Indeed, since then, bond yields in developed countries have generally risen to levels that are around two-year highs (though in absolute, historical terms they remain relatively low). To some extent this represented the Federal Reserve pulling US bonds kicking and screaming upwards, as it continued a steady upward move in the Fed funds rate (now at 4.75%, well above what consensus had expected a year ago.

In Europe official interest rates are on the rise - with more expected to come over the course of this year. But most interesting has probably been the confirmation of a structural change in Japan: the "end of deflation" has been proclaimed; the Bank of Japan has started to withdraw "quantitative easing" and is expected to actually raise rates sometime during the second half of the year.

Despite all this, emerging markets continued to perform well. The current line of thinking seems to be that despite the gradual withdrawal of liquidity, global growth remains robust and so emerging markets - most of which export commodities or are otherwise geared to the global growth cycle - will continue to perform well.

While accepting that this is a valid argument, we also remain somewhat cautious. South Africa will continue to do well as long as the general emerging market universe is in favour, but we note that some jitters have set in with some emerging markets (Iceland, Hungary) and some developed commodity exporters (New Zealand) finding their currencies under pressure. The rand did not escape a bout of the jitters, though at the time of writing it has retraced its losses. We remain concerned that falling global risk appetite will see currency weakening of countries that are running large current account deficits and in turn potentially place upward pressure on inflation and interest rates; South Africa would fall into this grouping.

Of course, local developments are also important in determining a final value for bond yields: while global bond market movements are likely to be a primary determinant of trend, local issues will affect South African bond spreads versus other countries. Inflation, while expected to drift up further from its trough, is not expected to provide any major scares (unless there is a sharp move downwards in the rand). However, other local developments support at best an unchanged repo rate, with risks that the next move is up - a point of view now publicly espoused by Governor Mboweni. The main concern from a monetary policy perspective at present is the booming domestic economy; while higher growth is good, the extent of what we are seeing appears to be stretching the economy's capacity. Such imbalances show up in the ever-widening current account deficit; if left unchecked to grow indefinitely, this will eventually become unsustainable with a potentially messy rand (and inflation) outcome as a result.

We would expect the upward drift in bond yields to continue this year. During the quarter we trimmed down the government bond position, mostly via the R194 and the R198, and increased our holding to a selection of corporate bonds. The inflationlinked bonds remain a core holding in the fund (6.5%) acting as an inflation hedge and portfolio diversifier. They contributed positively to the quarter's performance, with real yields having rallied again on the back of very aggressive demand.

Tania Miglietta
Portfolio Manager

The year 2005 will be remembered as the year that the rand remained relatively stable, a lower than expected inflation rate and the year in which interest rates ground lower. Lower volatility provided the undertone, with bonds trading for long periods of time in very narrow ranges. Higher levels of uncertainty leading to less trading activity and neutral positioning by fund managers tended to dampen the market. Foreign investors were evident in our market. They favoured local currency as opposed to foreign listed bonds showing their willingness to take on emerging market currency risk in their ongoing search for yield. As it turns out, emerging markets' bonds and equities were by far the best performing asset classes globally.
Although local bond yields have reached new record lows and the All Bond Index (ALBI) showed another year of gains, diminishing returns are setting in because of the base. While the ALBI returned 10.8% last year, this was in fact its weakest performance since 1998. Moreover, local bonds far underperformed a stellar equity market return of over 47% in 2005, although they did outperform cash of 7.1%. Most of the performance in the bond market took place in the last quarter. The fund's benchmark, the 1-3 year bond index, had only returned 4.9% by September, yet added another 2.8% in the last three months of the year.
The star performer for the year remained inflation-linked bonds, which delivered a 17.6% return - way outperforming cash and nominal bonds. These act as an inflation hedge for the fund and outperform when inflation rises unexpectedly. Inflation-linked bond real yields fell aggressively in 2005 mainly driven by an increasing number of products offering inflation protection. Such a structural shift pushed yields lower as these bonds are known to be illiquid and issued only at weekly auctions in relatively small volume.
The Coronation Income Fund returned 8.2% during 2005 and 2.1% for the last quarter of the year. This compares with 7.7% and 2.6% from the 1-3 year bond index benchmark respectively. The portfolio duration was increased in November when it became apparent that bonds would not sell off aggressively as inflation was likely to remain contained for longer. The Coronation Income Fund has held substantial holdings in both corporate and inflation-linked bonds all year, which has largely contributed to the fund's good performance. As at year end, preliminary figures showed that this was the only fund in its category to beat the benchmark.
The market has become very flush with cash which has put additional pressure on interest rates to fall. Finding attractive yields in this environment becomes increasingly difficult.
Looking forward, both global and domestic backdrops are likely to remain benign for bonds. Given our earlier point of "diminishing returns", we think that bond yields could be close to their lows, but even if they do fall further, this will be off an already low base and bonds will be hard pressed to match the returns seen in previous years.
Our strategy for the year includes identifying the remaining well-priced yield opportunities, being cognisant of the risks, and noting where South African interest rates have come from and how expensive many of these assets have become.

Tania Miglietta
Portfolio Manager