The fund generated a return (net of management fees) of 1.60% for the quarter and 6.09% over a rolling 12-month period, which is ahead of the 3-month STeFI benchmark return of 5.41%.

The third quarter of 2014 was an eventful one for fixed interest markets, with large swings in the currency and inflation, coupled with the failure of African Bank. However, despite these generally negative factors, fixed interest markets managed to produce a positive return for the quarter. The All Bond Index (ALBI) outperformed both cash (+1.43%) and inflation-linked bonds (+1.0%), gaining 2.2% for the quarter.

Money market interest rates reversed the decline from the second quarter as 3- and 5-year fixed bank rates pushed 40 basis points higher and bank funding spreads increased 25bps respectively on the 3- and 5-year tenor. Inflation surprised on the upside and remained above the top of the 3-6% target range, with August CPI rising to 6.4%. There were two MPC meetings in the quarter: the SARB raised the repo rate by 25bps to 5.75% at the July meeting, but left rates unchanged at the September meeting as the growth background had once again deteriorated. The major news at the September MPC meeting was the announcement by Gill Marcus that she would not be available for another term as governor once her term ends in November. (Deputy governor Lesetja Kganyago has since been appointed to replace Marcus.) Even as indications of falling food and energy inflation have lent some hope to the inflation outlook, the rapid rand depreciation near quarter-end kept fears of inflationary pressures alive. Comments by SARB officials have made it clear that we remain in a hiking cycle - policy is still very accommodative and needs to normalise - and that disagreements are over the timing of, rather than the need for, further hikes.

The rand depreciated 6% over the quarter, ending the period at R11.29/$. Forward rate agreement (FRA) rates, which serve as an indication of future repo rate movements, ended the quarter pricing in a 25bps repo rate hike in January 2015. Three month Jibar (3mJ) initially ticked up to peak at 6.133% in August. However, 3mJ closed at 6.075% as the SARB kept rates on hold at the September MPC meeting and expectations for further rate hikes were pushed to 2015. The economy remains vulnerable given the ongoing twin deficit situation, as fiscal consolidation is lacking (especially when compared to our peer countries) and the trade account is not able to benefit from a weaker currency (in significant part likely due to strike action). Partly due to these factors, foreigners were large net sellers of bonds in the third quarter (of almost R25bn).

Aside from economic developments, the local markets were shaken by the failure of African Bank (ABIL) in early August. The microlender was suspended from trading and placed under curatorship, with measures including being split into a good bank and a bad bank. While the final outcomes are still unclear, measures to date include a 10% haircut and maturity extension on senior debt, and the apparent complete loss of capital on subordinated debt. Coronation had held no ABIL debt in its bond or cash funds as we did not believe the returns available on that debt provided enough compensation for the risks involved. The outcome with respect to the debt, however, saw significant reverberations through the SA capital market: some bond funds were forced to either record losses or "side pocket" their ABIL debt; some money market funds "broke the buck"; and the effects on confidence saw credit spreads in general, and bank funding spreads in particular, widening.

The fund took the opportunity to acquire high-quality (with attractive yield) secondary instruments as funds caught in the ABIL web were sellers of these instruments in the market. The fund picked up some old-style Absa subordinated debt (sub-debt) at 185bps over 3mJ. With Basel III coming into effect, and the introduction of Contingent Convertible bonds that can be written down to zero by the bank regulator where bank solvency is at risk of deteriorating, old style sub-debt offers better protection to the investor. On primary issuance, the fund invested in a 5-year Capital Property Fund (CPF) bond at 140 basis points over 3mJ. CPF is highly cash generative with low loan-to-value (LTV), providing an attractive yield for the credit risk. As managers of the fund, we continue to seek attractive yielding opportunities while minimising interest rate risk.

Portfolio managers
Mark le Roux and Nomathibana Matshoba Client

The fund generated a total return (net of management fees) over the last 12-month period of 5.83%, ahead of the 3- month STeFI benchmark return of 5.03%.

Fixed interest assets returned to positive territory in December, after experiencing negative returns in the preceding month. However, 2013 was a poor year overall for fixed interest assets, with the annual return for both the All Bond Index (ALBI) and inflation-linked bonds lagging that of cash.

Bank fixed-rate NCDs ended the quarter an average 12 basis points higher across the curve, while bank floating-rate note spreads ticked up 5 basis points. At quarter-end, the FRA curve continued to price in at least two rate hikes within the next 12 months, with marginal change in the overall shape of the curve.

The poor performance from the fixed interest asset class was driven mainly by expectations around the tapering of quantitative easing (QE). After the initial announcement by the US Federal Reserve (Fed) in May 2013 that they intended to scale back their QE programme, and the subsequent speculation relating to the timing thereof, tapering was finally announced in December 2013. With effect from January 2014, the Fed will be reducing its monthly asset purchases by $10 billion (to $75 billion), following months of better than expected employment reports. However, the Fed statement contained what was deemed to be dovish comments relating to a delay in short-term rate hikes. In essence, while the Fed allowed long-term rates to drift higher, it stated that shortterm rates would remain lower for longer in the event that the economic recovery does not gain traction.

Turning to local fundamentals and statistics, the fourth quarter of 2013 saw a reversal in foreign flows into the local bond market. Non-residents were net sellers of R16.4 billion worth of South African bonds (from being net buyers of R14.8 billion in the third quarter of the year). This was the largest outflow from the local bond market since the fourth quarter of 2010. As a whole, 2013 saw just over R1 billion in foreign flows into domestic bonds - a far cry from the R85 billion recorded in 2012. With the net selling by non-residents during the quarter, the rand weakened further, ending the period at R/$ 10.49, compared to R/$ 10.03 at the end of the third quarter.

Third-quarter data for the current account showed a further deterioration to 6.8% of GDP, from 5.9% in quarter two. On the one hand, there was an increase in foreign direct investment (FDI) in the third quarter - a welcome development given South Africa's reliance on portfolio flows to finance the current account deficit. As highlighted previously, we believe that the end of cheap money will make it increasingly difficult for South Africa to attract foreign flows, given the challenging state of our fundamentals. Diversification away from portfolio flows to less volatile types of foreign flows, like FDI, would help alleviate pressure on the currency.

Meanwhile, the Minister of Finance tabled the Medium-Term Budget Policy Statement (MTBPS) in late October. While methodological changes led to a narrowing of the projected budget deficit for 2013/14 (from 4.6% to 4.2% of GDP), consolidation in public finances has been pushed out (again) by a year. However, the commitment to fiscal restraint announced by the Minister, including the expenditure ceiling and the cutting of perks to Cabinet shows a willingness on the part of the authorities to address the challenges SA inc. faces. Going forward, the growth outlook and its implication for government revenue collection will be critical in addressing the budget deficit.

GDP growth of 0.7% was recorded for the third quarter. The automotive sector strike negatively impacted the manufacturing sector, and hence GDP. After breaching the upper end of the target band in the third quarter, inflation dipped back within target in the first two months of the fourth quarter, with November's print at 5.3%. While this inflation print is likely to ease the pressure on the Monetary Policy Committee (MPC) to begin tightening policy, the volatility in the external environment and its impact on the rand have seen the South African Reserve Bank (SARB) strike an increasingly hawkish tone in recent meetings, with the underlying message (in our opinion) that if a weakening rand threatens the inflation outlook, interest rates will have to be hiked.

Corporate bond issuance over the quarter was relatively active, with names such as Mercedes Benz, PPC and Rand Water coming to the market along with some property companies and South African banks. Fourth-quarter issuance also saw issuers that have either been dormant or are new to the South African corporate bond market. These issuers include Delta Property Fund, Barloworld, Curro Holdings, Bank Windhoek, IDC, Super Group and HomeChoice Holdings. Although the universe of corporate bonds has increased, the fund did not participate in all the issuance as we believe our investors will not be adequately rewarded for taking on the credit risk on some of these.

This fund is suitable for money market investors with a longerterm outlook. The fund continues to seek attractive yielding opportunities, while minimising interest rate risk.