Bonds showed a marginally positive return in September, with the All Bond Index (ALBI) returning 0.08% and a respectable 3.0% for the quarter. Although the shorter maturity spectrum outperformed in September, it underperformed the rest of the index during the quarter, with long-dated bonds and non-government bonds in particular the best performers during the period. The third quarter also saw bonds outperform both cash (1.9%) and inflation-linked bonds (1.4%). Year to date, however, bonds still show a negative return, lagging well behind both cash and inflation linkers. The lacklustre performance of bonds in September was largely due to a weakening towards month-end, and this seems to have been largely influenced by the retracement in FRAs at the time (see chart below). These moves followed the South African Reserve Bank's decision to leave interest rates on hold at the September MPC meeting (following a surprise cut in August). Although unchanged rates had been consensus, it was clear that the markets were getting bullish on a possible rate cut and thus disappointed at the actual outcome.

Against that background, the bond market largely ignored what should have been positive factors on other fronts: during September the rand strengthened further, US bond yields fell and the Emerging Markets Bond Index spread contracted. Economic data remained mixed from a bond market perspective. While economic activity data remained weak there were some upside surprises and conversely, while inflation continued to fall, CPI is still above the target range. While the bond market does not seem to have taken much notice of the stronger rand, we would emphasise that should the currency stay around these levels for any length of time, it has the potential to positively (and significantly) influence inflation going forward. We have already had a 5% petrol price cut announced for October and a number of other categories - including food prices - will be positively affected by rand appreciation. Thus the risk is that inflation falls into target sooner than the market is currently expecting and that 2010 inflation is generally better than current market forecasts. The biggest concern probably remains the huge amount of bond supply to come to the market. The budget deficit has widened sharply in the first five months of the fiscal year as revenues show the effects of recession. While official numbers will be announced later this month in the Medium- Term Budget Policy Statement, it looks like the budget deficit for the current fiscal year will probably be well north of 7%. However, there was a tentative improvement in both revenue and expenditure in August after some terrible figures earlier in the fiscal year and the final outcome may well be better than what is implied by simply extrapolating the year-to-date numbers. Even so, the final number will still be large.

During September we continued to increase the inflation-linked and floating rate bond exposure in the fund. The fund, with a small holding in high yielding corporate bonds, is further positioned for rising interest rates and inflation over the next few years; more than 50% of the fund is invested in floating rate investments and 10% in inflation-linked bonds which will provide a natural hedge resulting in higher income for investors as inflation and/or interest rates rise.

Portfolio manager
Tania Miglietta

The All Bond Index (ALBI) gave up some ground in June, resulting in an anaemic return of 0.3% for the quarter. The shorter-dated area of the curve was the right area to be in, but that still underperformed cash (both in June and for the quarter as a whole). While inflation-linked bonds performed well throughout the period, they lagged cash in June. Year to date, inflation linkers have been the best performing asset class, followed by cash, with the ALBI lagging significantly behind.

A number of factors undermined local bond yields this year, and especially in the second quarter when yields failed to take much heart from, for example, a stronger rand. Also note that the lacklustre performance of bonds has happened despite the aggressive easing in short rates this year - the South African Reserve Bank (SARB) took just 6 months to unwind almost all of the tightening put in place over the two years from June 2006 to June 2008.

Firstly, consumer price inflation (CPI) has remained persistently high this year despite fast declining producer price inflation. While we may yet see some more rapid downward movement in CPI owing to the recent stronger rand, many analysts have revised their forecasts higher, therefore undermining longer-dated bonds, but adding support to inflation-linked bonds.

A second factor undermining local bonds this past quarter has been the rise in global bond yields. The US 10-year yield has risen from around 2.70% to 3.50%, threatening the 4% level at one point. As talk on the global stage has turned to recovery and with it exit strategies from the expansionary policies, including quantitative easing, global bond yields have risen. SA bonds often move in tandem with global bonds and this time has been no exception.

Thirdly, as fiscal positions almost everywhere have suffered from the economic slowdown (i.e. declining tax revenues as well as spending pressures), concerns started to mount about the large increases in the supply of bonds required to fund fiscal deficits. South Africa has been no exception to this, and just past quarter-end Finance Minister Pravin Gordhan announced some details of the revenue shortfall to date - significantly worse than many in the market had anticipated. From an originally budgeted deficit of 3.8% of GDP announced in February, it now looks likely that the deficit will surpass of 5% of GDP. Indeed, if trends do not improve from what we have seen so far in the fiscal year, it could even be in excess of 6%. While the exact intentions for funding this deficit remain unclear at present, what is clear is that the domestic bond market will not escape unscathed.

Finally, despite our earlier mention of the rapid unwind of last year's rate increases, note that the SARB paused its easing cycle in June against market expectations of a further 50bp repo rate cut. While this is positive for the bond market in the longer term (as it supports the longer term inflation outlook), in the short term it acted to brake potential gains in domestic bonds.

The near-term outlook for bonds remains murky. On the one hand, a positive argument can be made from the likely trends in CPI and the fact that the market may well have underestimated the effect of a stronger rand on pulling inflation rates down from current levels. But on the other hand, concerns about supply pressure will remain and may well weigh the market down for a while, especially while the exact composition of the revised funding requirement remains unknown.

Money market rates have fallen dramatically this year, but retraced by a percent in the 1-year area after the interest rate announcement in June. Both Treasury bill and corporate paper issuance have increased this year, taking substantial market share from the banks. This is starting to put some upward pressure on NCD rates. We took the opportunity to switch out of a few select corporate bonds and medium-dated RSA bonds just prior to the rates announcement, and switched the proceeds into the 1-year NCD at its higher levels.

We hold 4% of the fund in inflation-linked bonds which perform well in a high inflation environment. They are proving their worth as a good investment given how sticky inflation has been this year.

Corporate bonds, which include parastatals, are showing very attractive yields given new issuance (greater supply) in the market at ever-widening credit spreads. Issuers have been looking for funding via this market as bank funding becomes more challenging, and the bonds have been lapped up by funds seeking higher yields.

The fund has done particularly well in this volatile market, returning 13.5% over the past year. It continues to weather the storm of volatile markets in a challenging macro-economic environment by remaining invested in good quality credits with a high percentage to floating rate and inflation-linked investments functioning as a good interest rate and inflation hedge.

Portfolio manager
Tania Miglietta

Despite two consecutive higher-than-expected inflation releases in the first two months of this year, expectations of rate cuts intensified heading into 2009. This occurred as local and global economic indicators continued to show significant weakness coupled with developed country central banks increasing their pace of monetary easing via both interest rates and direct liquidity injections.

The bond market lost just over 5% in the first quarter of 2009, with the losses realised in January and February before the All Bond Index (ALBI) stabilised in March. There has been a significant difference in performance across maturity bands, however. For the quarter, short-dated bonds returned +2.3% while the longest dated bonds (12 years and more) lost 10.8%. The short end was supported by a 200bp reduction in the repo rate year-to-date and expectations of further aggressive easing. Meanwhile, the long end underperformed due to higher-than-expected inflation data and probably some concerns about the large amount of supply due to hit the market. This was coupled with a retracement in global bonds, which continue to have a strong influence on SA bonds.

The fund's exposure to shorter dated corporate bonds contributed greatly to its recent performance given their link to the R153 (RSA 2010 maturity) government bond, which rallied strongly and reach a yield to maturity of around 6.53% - an all time low. This after a big buy-back programme on these bonds got underway this quarter. On the negative side, corporate spreads have widened somewhat, reflecting the market's saturation of corporate debt and the increased risk prevailing at the moment. We do, however, see this spread widening as a very good buying opportunity for bond and income funds.

Against the economic background, SA money market rates continued their steady fall as prospects for lower interest rates became more likely. The Reserve Bank surprised the market with its call to meet monthly rather than bi-monthly, which signalled that the bank would accelerate repo rate cuts, although Governor Tito Mboweni subsequently said that the MPC would not feel compelled to cut rates at every meeting. On 24 March, at the first of the monthly meetings, the Governor announced a 1% repo rate cut, equalling the February cut and in line with expectations. This resulted in 2.5% in interest rate cuts so far in the current easing cycle, bringing the repo rate to 9.5%. The FRA market has been pricing in a quick succession of interest rate cuts, expecting the market to bottom out with the repo rate as low as 6.5% at one point. This has since been tempered somewhat, with a low of 7% now expected.

The fund holds around 40% in money market assets, with another 18% in floating rate corporate bonds. These act as an interest rate volatility buffer and have provided the fund with much needed protection during recent months. These assets also contribute to the overall yield of the fund as they are largely linked to JIBAR with a generous spread.

A new entry into this fund is a small holding in the ABSA inflationlinked bond which was bought at a real yield of 6% and will provide inflation protection going forward. Given market pricing on inflation-linked bonds relative to nominal bonds, we believe that the better value lies in the inflation-linked market.

The fund has a duration of 0.92, which is shorter than that of its benchmark, the 1 - 3 year Bond Index. Given the nature of its mandate to provide yield and capital protection where possible, we deem it prudent to remain just short of the index as we have with all of our other fixed income funds.

Bonds were the best performing asset class during 2008, returning an impressive 16.97% for the year despite a very bearish start brought on by a surge in inflation and sharply rising interest rates. Bonds looked set to produce negative returns for most of the year until July when the oil price started to fall and Statistics SA indicated that the CPIX index would be reweighted and rebased in January 2009. Calculations showed that inflation was indeed going to fall sharply.

However, this has taken some time to materialise and only in November 2008 did we see the first convincing decline in inflation.. By December, CPIX was at 12.1% - still high, but moving lower. Bond yields peaked in the third quarter falling sharply thereafter, anticipating an imminent turn downwards in the interest rate cycle. Bond market returns improved dramatically during the fourth quarter helped along by domestic investors piling in after months of being short duration. On the 11th of December SA Reserve Bank Governor Tito Mboweni announced the first 0.5% repo rate cut of the cycle, taking the repo rate to 11.5% after 10 consecutive hikes starting in June 2006. During December bonds touched 7% before ending the year slightly higher at 7.21%. The market is pricing a very bullish outcome for short term interest rates over the next year, and is expecting as much as a 1% repo rate cut in February, following with further cuts thereafter.

The fund was well positioned for this sharp turnaround in the bond market, with its substantial holding in corporate bonds which represents 30% of the fund and contributed to the stronger performance.

The fund's holding in both floating and fixed-rate money market NCDs are the income generators for the portfolio. These instruments still paying interest in excess of 12% p.a. and provide the fund with the required income for investors. The floating rate notes bought earlier in 2008 at a significant spread over JIBAR provided a good buffer to rising interest rates during the year. Money market rates, now much lower, are pricing in all of the expected interest rate cuts, and no longer offer the same excellent value that they did during 2008.

The fund returned a pleasing 12.2% for the year. We continue to be manage it conservatively, with the focus on income generation and looking for opportunities to generate capital returns from assets where the risk/return trade-off is in our favour.

Tania Miglietta
Portfolio Manager