The fund achieved 2.1% for the quarter and 8.8% total return for the 12 months to end September 2010. The fund's daily running yield at quarter-end was 7.96%. This compares extremely favourably to prevailing wholesale call rates which are now as low as 5.7%.

The big news this quarter came on 9 September when the Monetary Policy Committee (MPC) announced yet another 0.5% reduction in the South African repo rate, taking it to a new low of 6.0%. This came after a series of interest rate cuts, followed by a number of pauses. The current downward cycle in interest rates began in late 2008.

The MPC decision was not entirely surprising given that consumer inflation, now at 3.5% year-on-year in August, has been falling to new lows. This has been largely due to ongoing currency strength, assisted by foreigners searching for yield in emerging market bond markets, including that of SA where they have invested around R70 billion year to date. The SA Reserve Bank expects inflation to bottom this year and then rise to an average of around 5.1% by the fourth quarter of next year. These figures all remain well within the 3% - 6% target range.

Money market investors seeking to maximise their interest income do suffer when interest rates fall to very low levels. As seen in the chart above, the previous lows of 2005/2006 lasted a year, but turned sharply upwards on the reversal. We believe that interest rates going forward are likely to follow a similar course.

The fund was recently restructured to provide investors with a modified duration of no more than 90 days, thereby minimising interest rate risk, but at the same time providing a very good yield pick-up. We have invested fully in long dated floating rate notes (FRNs) at very attractive yields. To date, banks and corporate issuers looking for 2 - 5 year funding have been tapping into the FRN market aggressively and at times have offered excellent spreads over 3-month JIBAR, the market's main reference rate. We saw great value in these and identified them as being highly suitable for a low risk, high yield product such as the income fund. The fund currently achieves an average yield JIBAR + 1.4% before fees, a spread that has been locked in for the next few years.

The fund is focused on achieving the best money market returns available in the market by participating in an area of the yield curve which, to date, has offered excellent additional yield without much more risk. We believe that this is the best way to beat the low interest rate blues which can set in at these low levels.

Portfolio manager
Tania Miglietta

Bonds returned 0.27% in June, short of the cash return of 0.56% and lagging well behind inflation-linked bonds which returned 1.3%. The fund returned 0.72% for the month and 1.91% for the quarter.

The past quarter was largely dominated by a combination of global fears about sovereign debt (especially in the European peripheral countries: Greece, Spain and Portugal), and domestic news that showed a combination of economic recovery taking hold, with CPI inflation continually coming in lower than forecasted.

Although the massive IMF/EU rescue package announced in May helped stem the spiral that had been seen in peripheral euro markets in general and Greece in particular, it is clear that these economies are by no means out of the woods.

Support for local bonds has come from a number of sources. As with other emerging markets, SA has also seen inflows. Foreigners bought a net R33 billion worth of local bonds in the first six months of 2010. This has clearly been a source of support for local bond yields, helping offset the increased supply associated with SA's currently large budget deficit. Local news has generally been positive for bonds. The 'Goldilocks' outlook that we alluded to some time ago has materialised, with CPI inflation surprising most initial 2010 forecasts on the downside while growth has exceeded initial expectations. CPI printed at 4.6% in May, comfortably in the middle of the target range, while GDP grew by 4.6% in the first quarter, with export sectors as well as domestic consumption showing a rebound. This in turn has been positive for the fiscus, and the indications so far this year are that the Budget deficit will come in significantly below the initial Treasury estimate of 6.2% of GDP. This should help relieve funding pressure.

While CPI is expected to still fall slightly from its current levels, we think the bottom is near. A potential rise in CPI (especially if the rand weakens) combined with stronger domestic demand and already very low real interest rates, leads us to think that further interest rate cuts are unlikely. Rather, the next move is deciding when factors will combine in such as way as to induce the SA Reserve Bank to start hiking rates (although such a move is probably a year away yet).

The fund is designed to maximise yield over time and given the current low point in the interest rate cycle, the fund has continued to invest in longer dated floating rate investments as this is where we see the best value. Issuance in 2 - 4 year floating rate notes has been strong. The fund holds 65.8% in floating rate investments which under current credit conditions pay an attractive spread averaging 1.5% over the JIBAR reference rate. These act as a good interest rate hedge when interest rates begin to rise.

Inflation-linked bonds had a good quarter returning 5.1% versus nominal bonds which returned 1.1%. The fund holds 10% in these inflation-hedging investments as a core holding.

Portfolio manager
Tania Miglietta

Bond yields have been in a general downward trend since mid-January, a trend that was maintained in March and gained momentum following the South African Reserve Bank's (SARB) decision to cut the repo rate by 50 basis points (to 6.5%) at the MPC meeting on 25 March. The SARB's move, which had not been fully discounted in the markets, was enabled by a combination of lower-than-expected inflation, and generally still soft economic data as well as continued rand strength which bode well for further disinflation. At this stage, we believe that most of the expected good news is factored in, and our base case would be for rates to remain on hold for the remainder of this year.

Inflation re-entered the 3% - 6% target range in February at 5.7% (data released in March), which was sooner than many had expected. We think that underlying trends in consumer inflation look positive, while a broad number of categories continue to show beneficial influences from the currency. Indeed, most of the rand-sensitive categories are either within or below the inflation target range. The main factors holding inflation up continue to be administered prices, and even these appear to be less of a problem than had initially been expected (e.g. the Eskom price increase being approved at a lower level than requested). We think CPI could fall to around the mid-point of the target range during the course of this year. Movements in the rand will continue to be crucial, and a reversal of rand strength remains a key risk.

Although growth has undoubtedly bottomed and is moving noticeably higher, this so far seems to be led principally by manufacturing (linked to exports and the global recovery) and domestic car sales (coming off an exceptionally battered base).

A latent risk for both SA and emerging market bond yields in general arises from the US bond market, where yields have recently moved higher on a combination of stronger growth data and large supply, even despite expectations of interest rate rises being pushed out as core inflation surprises on the downside. As quantitative easing programmes start being wound down, we expect that supply issues will continue to dominate US and other developed bond markets - and at some stage, though now it is looking more likely to be in 2011, major central banks will have to start reversing emergency low levels of interest rates as well. It is thus difficult to see an outcome where global bond yields do not continue rising into 2011, and this will almost certainly have an impact on SA yields as well.

The fund is focused on providing a good yield for investors and does not take the same capital risk positions as a bond fund would. It returned 2.60% for the quarter and 9.09% for the last 12 months, largely due to fixed and floating rate corporate bonds and floating rate bank investments which provide a good interest rate buffer when domestic interest rates eventually start to rise. A detractor has been the holding in inflation-linked bonds which have not performed well in recent months as inflation has surprised to the downside. The total return from the 2013/2014 maturity inflation-linked bonds held in the portfolio should accelerate when inflation starts to rise. The fund's current yield to maturity of 8% gross of fees is greater than that of a traditional money market fund, due to a yield pick-up achieved from the longer date maturities in this fund.

Portfolio manager
Tania Miglietta

The All Bond Index (ALBI) which returned 1.1% for the quarter had a very disappointing year, achieving a paltry negative 1% and underperforming cash by close to 10%. Shorter dated bonds, which did not suffer the same sell-off, returned around 7.7% in comparison. Inflation-linked bonds, although having returned just less than cash for the year, performed better than nominal bonds. The combination of an improved inflation outlook as well as continued significant supply of inflation-linked bonds weighed heavily on the asset class and real yields traded higher.

The portfolio holds around 11% in inflation-linked bonds, most of which were issued by corporate entities and provide additional yield which adds to the overall return during a time of flat to falling inflation. We will continue to hold these for the long term given the favourable yields at which they were bought. High yielding, short dated corporate bonds and floating rate money market investments make up the remainder of the portfolio.

The weekly supply of new government debt remains to be the proverbial 'elephant in the room' putting pressure on the bond market. During November the National Treasury stepped up its nominal bond funding requirement to R2.1 billion and its inflation-linked bond issuance to R600 million per week. This R600 million face value equates to a cash outlay of around double that of the nominal amount. The numbers add up to billions needed each month and added to that is the continued state-owned enterprises (SOE) issuance such as Transnet, Eskom and the Development Bank of South Africa.

Balanced against the negative story from the supply side is the improving trend in the inflation outlook. We ended 2009 with a year-on-year CPI figure for November of 5.8% which is now within the 3% - 6% target range for the second consecutive month. Continued rand strength coupled with weak money supply and negative private sector credit extension bodes well for the inflation outlook for 2010.

Despite the positive inflation story, the heavy bond supply has prevented the bond market from responding positively.

Risks to our relatively benign inflation outlook in 2010 come from a potential unwinding of the base effects of the lower food and fuel prices experienced in 2009, uncertainty over electricity price increases and the chance of a severe bout of global risk aversion which could result in a sharp retracement in the rand.

Portfolio manager
Tania Miglietta Client