In recent weeks, the US and European financial institutions experienced unprecedented turmoil in the money markets in which they operate. The US Federal Reserve and Treasury, the Bank of England, the European Central Bank, and national Treasuries are all stepping-in to provide capital (or a rescue plan) to institutions that have had difficulty receiving daily funding. This is in a market which is in a gridlock and hoarding cash. In some cases, financial institutions have been bought up or nationalised, and in others depositors' funds have been guaranteed by the respective central banks.

We draw your attention to our view that this is very much an offshore banking problem, something from which South African banks have been largely protected. The primary reason for this is the existence of SA Foreign Exchange Controls which prevent local banks from participating aggressively in the broader international banking environment. The controls have also ensured that most of the SA banks' funding is from SA sources, which has prevented their liquidity from being threatened by nervous international funders.

The SA Reserve Bank requires that SA banks be well capitalised and that international banks operating in SA do so as a full branch of the parent company where all local deposits are fully guaranteed by the parent. Further to this, exchange controls also prevent these banks from placing excessive amounts of SA depositors' cash in the international arena.

We are comfortable that the SA banks are sound. They are not experiencing funding difficulty and are most unlikely to suffer the same problems as their international counterparts are currently undergoing. It is also important to note that the SA banks carry a strong support rating by the SA Reserve Bank.

The Coronation Income Fund has weathered the financial markets storm relatively well, with its high exposure to SA banks in the money market contributing to the fund's overall running yield of 12.12%.

During the quarter the fund's duration was kept just short of benchmark duration, given the market volatility. Bond exposures, made up of a few select corporate bonds accumulated at the higher spreads, fared well as bonds rallied after reaching a high of 10.85% (see chart below). The portfolio holds no RSA bonds as we see better value in the corporate sector and have a 20% holding in floating rate bonds, which offer a very attractive spread over JIBAR, the reference rate to which yields reset each quarter. The strong bond market despite a weaker currency (with its inflation implications), may seem odd. However, it bears similarities to September 2001, when bonds strengthened despite a weakening rand - seemingly the only refuge for exchange control-constrained fund managers against a background of sharp equity weakness. Of course, a few months after 9/11 we saw a very sharp and nasty retracement in bond yields, but that did follow further sharp rand weakening and a change in expectations about SARB rates from further cuts, to hikes. None of these factors are what we currently expect.

There is perhaps a mitigating factor this time around, which is the fall in commodity prices have offset the recent sharp depreciation in the rand. At the moment, we still expect to see interest rate cuts from the second quarter of 2009. However, the fact that bonds have run so far despite the increase in risk does make us cautious on the near-term outlook.

While we have been saying for some time that bonds offer value on a long-term basis, the sharp moves over the past quarter have, in our opinion, more than priced that in. We do not feel that the market is adequately pricing in the short term risks and bonds are now looking overvalued.

The Coronation Income Fund continues to be conservatively managed with the main focus being on generating yield and managing interest rate and liquidity risk. The fund returned 4.6% for the quarter and 9.3% for the last 12 months, outperforming its benchmark which returned 8.5% for the 12 month period.

Tania Miglietta
Portfolio Manager

The past quarter can only be termed as the bad news quarter, which came through in big waves, bringing with it higher price volatility and ever decreasing confidence. Compared to a year ago, there is not much to be happy about. But knowing that markets work in cycles and always bounce back, the current market presents a great buying opportunity for long-term investors.

Bonds sold-off in dramatic fashion over the quarter as inflation worries escalated. The All Bond Index lost 4.9% and 6.7% for the year-to-date. The R157 (2015 maturity) opened the quarter in April at 9.2% and sold-off, with the yield to maturity moving all the way up to 10.85% - levels not seen since 2002. The benchmark returned -1.3% for the quarter versus the Coronation Income Fund which outperformed with a return of 1.01%. The safest place to be this quarter was in cash and the fund has been relatively heavily invested in this sector all year.

We saw the repo rate being raised by a further 1% over the period (0.5% in April and June), taking it to 12%. Short term interest rates have more than doubled since the beginning of this interest rate cycle, with deposit rates now at 14%, compared to 7% in 2006. We have been switching into floating rate money market investments given the uncertainty of the interest rate outlook. The fund's duration has been around 1 during this time, which is half that of its benchmark. We look to increase this over time.

With the bond market sell-off, bonds have become increasingly attractive and our fair value models are signalling that value is starting to return to this area of the market. However, given the negative backdrop and the risk of the oil price continuing to push inflation higher, we are erring on the side of caution and await confirmation that we are indeed at the top of the interest rate cycle before adding bonds.

Eskom's tariff increase for this year of 27.5% was confirmed in June. When factored into inflation, the CPIX forecast peaks at over 12% - clearly a worrying figure. Once again, inflation is a cycle and the ten interest rate hikes to-date are designed to bring down inflation. Economists furthermore expect the decline in inflation to be aided by the 5-yearly re-weighting of the CPIX basket in January 2009.

The rand price of oil is up more than 100% from a year ago. The direct contribution to inflation from oil has been huge, which is quite clearly visible in the petrol price. But the indirect impact of higher oil prices is also notable, take for example the price of maize. Two important inputs into maize production are diesel and fertiliser, both oil by-products which are now causing a renewed surge in the maize price. It would appear that inflation and interest rates will deteriorate further before declining.

Money market rates have topped out but the FRA curve continues to price in a further 1% hike in interest rates (reflected in the 1 year NCD rate of 14%). 53% of the Coronation Income Fund is invested in floating rate investments which reset every 3 months as interest rates move higher. These act as an interest rate hedge and provide an average yield of 0.5% over JIBAR, which equates to approximately 13%.

The Coronation Income Fund has a running yield of 12.4% (before costs).

Tania Miglietta
Portfolio Manager

The Coronation Income Fund has weathered the global stock market storm relatively well, beating its benchmark and returning 1.86% for the quarter. We continue to manage the fund in a conservative and focused manner, especially during a time when the news is overwhelmingly negative. We do however remain cognisant that this is when many good opportunities emerge.

Until now we have largely held short and medium dated corporate bonds and money market assets, with 25% of the fund held in floating rate investments which have acted as a buffer against rising interest rates.

Money market rates are holding up in a market where ongoing repo rate hikes are still on the cards according to some economists. 12-month rates are trading above 12% and FRAs, which reflect the market's expectations for short term interest rates, are pricing in an 80% chance of another interest rate hike in April 2008.

Going back, we note that the SA bond market had a particularly poor start to the year. The all bond index returned -1.88% for the quarter and -0.53% for the month of March. The long end of the yield curve was the hardest hit with the 12+year bonds losing in excess of 6.5% for the quarter, while the 1 - 3 year component achieved the highest return of 1.6%. This weak performance from the bond market was fuelled by further negative surprises on CPIX inflation, a sharply weaker currency, an intensification of the credit crunch overseas (with the Bear Stearns distressed buyout by JP Morgan) and a widening in emerging market spreads. Needless to say, in this environment the all bond index once again underperformed both cash and inflation-linked bonds during the quarter.

Looking forward, our analysis shows that we are currently very close to the peak in inflation. It is important to remember that inflation is a means of measuring the rate of growth of prices, which means that prices remaining high do not mean high inflation. Food prices, although not falling yet, are in the process of topping out supported by the huge supply response domestically. Oil remains an enigma and is likely to remain at speculative levels as long as geopolitical tensions persist in the Middle East. However, the one wildcard has to be electricity - to go from a 14% increase to a requested 60% in the space of a few months begs many questions? If the regulator grants such an increase, we could see the inflation rate peaking in double digits of around 10.50% by July of this year.

Evidence in the economy suggests that the past eight interest rate hikes, taking us from 7.00% in June 2006 to 11.00%, are in the process of working. Retail sales and vehicle sales are already under enormous pressure, with more to come as the lagged effect of monetary policy (12 - 18 months) works its way into the system. While the full effects of the four interest rate hikes in 2007 have not yet fully filtered through, any excess consumer demand in the economy has shown signs of abating. 'Yes' we have an inflation target, and 'yes' we are in breach due to factors beyond our control, namely oil and food. But would a further interest rate hike help? Or would the impact on the consumer be the equivalent of 'pushing on a piece of string?' That said, any further rate hike impact on the rand could present a different story.

The turmoil in global credit markets has put the local corporate credit and securitization markets under severe strain. This, coupled with incessant funding pressure from the banks, has resulted in these markets virtually ceasing to function. Examples are the recent shelving of a home loan securitisation by one of the big four banks through lack of demand; The Development Bank of Southern Africa issuing only R1billion of a proposed new R2 billion bond due to lack of bids, and most recently, the large blue chip, Anglo American being forced to withdraw their inaugural bond issue due to insufficient demand at a reasonable price (140 bps over the referenced Government bond).

Maximum exposure to corporate credit by institutional investors and a lack of liquidity in the majority of credit issues has all but caused trade in this market to dry up. Furthermore, one of the largest money market unit trust funds in the country which had been an aggressive accumulator of bank conduit paper (a regulatory arbitrage vehicle that invest predominantly in securitisations and corporate credit) has virtually withdrawn from this area of the market, leaving it and the credit market in an oversupplied position.

A further problem in the credit market has been the lack of realistic price discovery and unrealistic mark to mark of a number of the assets due to poor tradability and lack of liquidity. A deteriorating economic outlook and rising interest rates have also put pressure on a number of the underlying assets in the securitisation vehicles.

This rather toxic concoction will need to right itself before vast sums of planned new issuance can find its way into the bond market. That said, we believe that the time to pick up bargains in this area of the market could be now.

We should be approaching the cyclical peak in inflation and from a fair valuation point of view bonds are beginning to show value. Thus we would advocate starting to lengthen the duration of the Coronation Income Fund. The fund currently is very short modified duration, at 1.37 versus that of its benchmark, 2.03.

Tania Miglietta
Portfolio Manager

The SA bond market returned 0.9% for the quarter. This lacklustre performance should be seen in the light of more negative surprises on CPIX inflation; two interest rate hikes, an intensification of the credit crunch overseas, and a widening in emerging market spreads. Against that backdrop, the fact that bonds managed a positive return is actually not bad at all! The only really supportive factor was a decline in US bond yields, though that was largely a combination of flight-to-quality bids and fears about US growth, neither of which is particularly healthy for SA. The rand moved largely sideways over the quarter, with a brief spurt of strength in late October/early November proving unsustainable. The all-bond index underperformed both cash and inflation-linked bonds for the quarter and the year.

Each of the three CPIX inflation releases during the final quarter of the year surprised market forecasts on the upside, and the end result was that CPIX had moved up sharply from 6.3% in August to 7.9% in November. This is well above the upper limit of the SA Reserve Bank's (SARB) 3% - 6% target range. The December figure, to be released at the end of January, will almost certainly be well north of 8%. The fact that the driving factors behind the inflation rise remained food and energy added to the SARB's concerns about second-round effects, and the data most probably sealed the decision to raise the repo rate 50 basis points at each of the October and December MPC meetings. The repo rate has now increased by a total of 400 basis points in this cycle.

However, the news was not all bad from an inflation perspective, and indeed from a forward-looking standpoint there are clear signs of improvement. The rand has generally remained stable (not just over the quarter but throughout 2007) and the lagged effect of this will help dampen CPIX beyond the first quarter of 2008. Indeed, the stable rand has already had something of a positive impact on PPI, and unlike CPIX that has tended to surprise on the downside. PPI is a leading indicator of CPIX trends. Meanwhile, the SARB's other stated concern - consumer spending - has shown signs of a sharp slowdown in recent data, and it can only be a matter of time before this is reflected to an acceptable extent in the credit data.

The SARB continues to find itself in a tight spot, with no sign of pressure easing on food and fuel prices, yet all indications are that more than enough pressure has been brought to bear on consumers. There must be a limit to the extent to which exogenous factors (and here we would include Eskom tariff increases) can drive monetary policy in the face of slumping consumer spending. It may be an opportune time to stick our necks out and say that it is likely time that the SARB will pause at the January MPC to see the effects of previous rate hikes - particularly if it is forward-looking.

The international backdrop will continue to be crucial. There are heightened concerns about growth in certain developed markets, particularly in the US. This could keep US bond yields low. However, if the credit crunch continues, risk aversion may stay relatively high and risky assets may stay under pressure. Capital flows into SA have been a key factor supporting the rand in the face of the wide current account deficit, and the rand could become vulnerable if sentiment towards emerging markets in general turns negative. This will remain a key risk this year. A positive side effect may be that concerns about growth should help alleviate some of the pressure recently seen on oil prices.

From a domestic perspective, the outlook is cloudier in the shorter term than the medium term. CPIX is expected to remain elevated in the first quarter, but should begin declining meaningfully from the second quarter and should slip back inside the target range by the third quarter. Coupled with what we expect to be continued evidence of a consumer slowdown, this should provide space for interest rate reductions in the second half of this year. This more positive outlook for bonds is again predicated on the assumption that any depreciation in the currency will be moderate, and is again held hostage to developments in oil and food prices. While the medium term outlook is basically positive, therefore, it remains fraught with risks and the SARB is likely to remain cautious. This fundamentally positive outlook tempered by a number of risks probably argues for keeping duration just short of the benchmark for the fund. The 1 - 3 year Bond Index had duration of 2 at year-end.

The portfolio is currently positioned for the top of the interest rate cycle via the large holding in high yielding NCDs and high yielding corporate bonds. This positioning enables us to achieve a duration of 1.4 without losing out on yield. The portfolio is yielding 11.34%.

The fund continues to be managed with the main focus being on achieving a high yield for investors, taking cognisance of the volatility inherent in the market during the quarter, and the speed with which the interest rate cycle can turn. We have been overweight the short end of the yield curve which has continued to rise, but note that during December after the last MPC meeting, the curve stabilised. We expect that the yield curve will start to normalise bringing short-term interest rates lower during the course of this year.

Tania Miglietta
Portfolio Manager

The fund may invest in a wide array of interest-bearing instruments but the average maturity of the underlying securities is limited to a maximum period of two years.