The bond market staged a rally in September, helping to lift the All-Bond Index (ALBI) to a 3.4% return for the third quarter. This was one of the few times over the past year where bonds have outperformed both cash and inflation-linked bonds. The 1 -3 year Bond Index returned 2.7% for the quarter, however significant weakness in the bond market in the May-August period is still depressing longer-term returns.

The SA Reserve Bank raised the repo rate another 50 basis points in August, bringing it to 10%. While concerns around inflation lingered with a string of worse-than-expected data releases, sentiment started turning after international factors took the lead role. As concerns about the sub-prime fall-out's impact on financial markets spread - the market started to price in a US rate cut. The Federal Reserve duly delivered, even surprising the markets with a 50 basis point cut at its September 18 Federal Open Market Committee (FOMC) meeting (most analysts had expected 25 basis points).

The Fed's move reignited interest in risky assets, with SA bonds joining a general emerging markets rally. The dollar has also come under pressure recently, and the rand has benefited handsomely from this, once again breaking through the R/$7 level. Given the importance of the rand to SA's inflation outlook, and against a background of near-record highs in global food and energy prices, the currency move is a welcome respite.

SA's current inflation situation remains an uncomfortable one. CPIX has been above the upper limit of its 3% - 6% target range since April, and will probably be there until March 2008: representing a full year above the target range. While much of this impetus has been driven by higher food prices and last year's rand fall, the SARB remains concerned about credibility. On a longer-term view, however, the big picture is rosier. Even with the lags involved, it is already clear that consumer spending and consumer credit cycles have turned as the effects of past rate rises start to bite. At the time of writing the October MPC has yet to take place; while it will be a close call, we think there are solid arguments for leaving rates unchanged. If they do rise again, it should clearly be the peak in the cycle. On the current outlook, we see scope for the repo rate to start falling in the second half of 2008.

We have taken advantage of higher bond yields and started to buy back select RSA government bonds. We also participated in the Nedbank bond issue which was issued at a very attractive credit spread of 1.85% above RSA government bonds. Money market interest rates held their mid-10% levels, with 1 year NCDs hovering close to 11%. The higher interest rates seen in the 2-3 year term have now been priced out on the recent bond rally. The chart below shows how money market interest rates have risen since the first repo rate hike in June last year.

The fund has a 44% holding in low risk high yielding money market NCDs, with some up to 3 years in term. We have locked into very attractive yields for the next few years.

International money markets reached crisis levels in both the US and Europe this quarter, with sub-prime loans hitting the short term securitisation markets (asset backed commercial paper - ABCP) severely, and drying up issuance thereof. The lack of liquidity has been a big issue in international money markets to which in some cases, banks have had to provide emergency liquidity. In SA we were somewhat shielded from the international money market volatility as SA banks are not exposed to the very risky securitisations which caused the credit crunch and default worries.

The fund has not participated in SA-listed long-term securitisation in recent years, since pricing never fully compensated us for the lack of liquidity (ability to sell) or the credit risk that these investments represent. Securitisations will come under further pressure as interest rate hikes hit the consumer, and their ability to repay loans (home-loans and vehicle loans) directly impacts the securitisation's own ability to pay noteholders' interest and capital. It therefore remains imperative that we price for worst case scenarios and poor liquidity when approaching this sector. The pricing has since improved notably in the form of widening credit spreads, but we continue to approach it with caution.

The Coronation Income Fund which is currently yielding around 10.09%, returned 2.3% for the quarter.

Tania Miglietta
Portfolio Manager

June was not a good month for bonds and other interest rate sensitive investments. A general sell-off took place as inflation and interest rate worries filtered through. The 1- 3 year bond index, returned 0.7% for the quarter, underperforming cash.

The interest rate picture took a turn for the worse in second quarter as inflation data exceeded expectations. CPIX breached the 6% upper end of the target range and the SARB responded by raising the repo rate another 50 basis points in June (having been on hold at the February and April meetings). Pipeline pressure continues to be evident in PPI, and CPIX is expected to remain above 6% for most of the next three quarters. This, and the potential effect of higher inflation on inflation expectations, means it is likely that the SARB (also with an eye on its credibility) will raise rates again at the August MPC.

However, it is noteworthy that while consumer demand data are generally still strong, there are clear signs of the peak having passed. Car sales are slumping, while other spending and consumer credit are starting to slow, hit by a perfect storm of higher rates, higher prices and (in June) the introduction of the National Credit Act. A consumer slowdown will help ease concerns both over the current account deficit and inflation further down the line, while the latter will also be helped by the recently stronger rand. Thus, if the SARB does raise rates in August, there is a good chance that would be the end of the cycle.

1 - 3 year money market investments continue to provide very attractive yields of well over 10%. The market has been very bearish, pricing in up to two more interest rate hikes of 50 basis points each. Low risk money market returns are showing exceptional value relative to other asset classes over the next 12 months.

The bond market sell-off that ensued this past month gave us renewed opportunity to buy more bonds after having held off for the last few weeks.

The fund continues to look for pockets of opportunity to enhance returns at the right price and strives to minimise downside risk where possible. For the quarter, the fund returned 0.88%, outperforming the index.

Tania Miglietta
Portfolio Manager

The Coronation Income Fund achieved a return of 1.91% for the first quarter, compared to its benchmark of 2.17%. The fund yielded 9.23% at quarter end.

We enjoyed a bullish start to the year with the R157 (2015 RSA bond) opening with a yield to maturity of 7.73% and trading to a low of 7.5% by late February. This was driven by the dovish stance taken at the February MPC where the committee's decision was to leave the repo rate unchanged at 9%. By then the inflation outlook had improved, the committee highlighted that credit extension although still high, had become more corporate driven.

It therefore meant that consumer borrowing was not as rife as previously recorded and since corporate borrowing is healthier for the economy than is consumer borrowing (since more investment and development is taking place). This and other important factors gave the SARB reason to leave interest rates unchanged.

Around six weeks later, the landscape started to change however, with higher oil prices, a weaker rand and later, higher maize prices creeping in. These all pose greater risks to future inflation. None of these prices have yet subsided, and effective early April, a large petrol price hike of around 68c per litre was imposed. So the risks to higher inflation remain.

In response to the changed landscape, although with a bit of a delay, the bond market sold off giving back most of its gains. The R157 closed the quarter just higher than its opening level at a yield to maturity of 7.82%. The All Bond Index (ALBI) returned 1.6% during the quarter, which is less than cash achieved (2.04%). Within the bond sectors, the 1-3 year index was the best performer for the quarter (+2.1%) and the 12+ year index, the worst performer (-1.07%). Inflation linked bonds only returned 1% during this time. The 12-month return from bonds at 5.6% has still been dismal compared to cash at 7.8%.

On that note, money market yields have been more volatile than usual, mostly in response to the weaker rand and the other inflation risks. The FRA curve, which acts as the market barometer for short-term interest rate expectations, is now pricing in around a 35% - 45% chance of another repo rate hike either in April or June. One-year money market yields are as high as 9.70%, up from previous weeks. The large SA banks seeking more funding to provide for their ever growing loan book are increasingly willing to pay up for long-term deposits. 18- month and 2-year money market interest rates are now paying 9.60% pa. This is certainly a better return (and lower risk) than expected bond returns for the next year.

The Income Fund has remained at around benchmark duration, of 1.5 years, with recent downscaling to 1.36 years given our concerns over inflation. The fund is composed of 61% money market investments earning between 9.2%-9.7%, a zero exposure to government bonds as at quarter end and a close to maximum corporate bond holding of 39%.

During the quarter a number of new corporate bonds and securitisations were brought to market. In most cases, the pricing was not attractive enough for the risks assumed and so we did not participate. However, we did introduce the AB07 (ABSA, 2014 maturity) into the fund as this AAA-rated bond was listed at a yield to maturity as high as 1.2% over the equivalent RSA bond. Such spreads on good quality bonds have not been around for more than a year now.

We note that the corporate bond market has become more of a buyer's market, as issuance has increased dramatically (as companies and banks seek cheap funding). Supply now exceeds demand and the pricing reflects this. Credit spreads on many of the corporate bonds, especially the longer dated bank bonds, have widened substantially since issue. Eg Nedbank 2018 was issued at 0.64% over the R201 and is now trading at 1.22% resulting in some capital loss to the investor. We were not invested in longer dated corporate bonds.

Tania Miglietta
Portfolio Manager

The Coronation Income Fund only participates in bonds and money market investments, designed to achieve a high yield for investors. It is lower risk than a bond fund.

The fund produced 5.9% for the year and has since inception returned 11.4% per annum. At the close of the year we saw bonds record new lows of 8.01% (R157, 2015). Given where bond yields were in September 2006 (8.90%), the market corrected substantially, taking bonds back down to what we term fair value. In recent months, rising short-term interest rates dominated the fixed interest market causing the yield curve to rise, especially short-term interest rates and volatility. This resulted in poor bond performance for much of that time, but some of this has since reversed. Inflation worries are subsiding given that the repo rate was hiked four times from June to December 2006. The bond market views this positively and subsequently traded better towards the end of the year. For 2006 the All Bond Index achieved a return of 5.5%.

The bond market's most recent rally in December was fuelled by the better than expected November CPIX and PPI figures. CPIX came out at 5.0%, unchanged from October and below forecasts of 5.4%, while PPI was 10% year on year, also better than expected. Part of the reason for the lower than expected figures was a muted increase in fresh food prices, which is an important component of the inflation measure. The oil price remained flat for the year and the currency, although depreciating at one point turned around and made back some of its losses. These two factors, as we've noted before, are important for the direction of inflation.

Money market interest rates rose on the news that the South African Reserve Bank hiked the repo rate to 9%. However, looking forward, the market is no longer expecting interest rates to continue rising, instead, it sees a possible pause in the interest rate hiking cycle and possibly a repo rate cut within 18 months to 2 years.

In the portfolio, bond holdings were increased around September when the market sold-off as explained earlier. With the re-entry into the government bond market the fund duration was increased to 1.5 years versus that of its benchmark of 1.1 years.

Tania Miglietta
Portfolio Manager