Domestic money market interest rates rose to attractive levels this quarter reaching a point where their relative attractiveness is becoming apparent. Investors should note that the expected return (for a very low risk investment) of one year is now over 9.60%, appealing when other riskier asset classes such as bonds are expected to provide around 8.90% for the next year. A better risk-adjusted return can therefore not be ignored.
At the start of the quarter one year money market interest rates were paying 8.70%, and have risen to 9.60%. Similarly structured two-year money market investments are paying slightly more - around 9.70% per annum but for two consecutive years. These one-year NCDs which pay regular interest have been our main investment focus in recent months, believing this type of asset to top all other fixed interest opportunities at the moment.
During a time of rising interest rates and tighter monetary policy (as a result of the two consecutive 0.5% repo rate hikes seen in both June and August this year), credit spreads would tend to rise, as risks increase. We have noted however, that this has not necessarily been the case in domestic markets this time around as spreads have remained remarkably stable. We attribute this to the very high demand that continues for non governmentguaranteed investments such as securitisation. We have seen an enormous amount of corporate credit but especially "securitisation" being issued to institutions in the market, and remain wary of taking on additional exposure in this asset class as we believe that the tide has turned on the good times for now, and that higher interest rates are starting to impact on the consumers' ability to repay all of the debt that they have taken on.
We therefore favour bank issued over non-bank issued paper where liquidity is high and interest rates attractive, investing only where we believe we are being fully compensated for the risks. In turn we have increased the duration of the portfolio to its maximum of 90 days, by buying up as much of the attractive one-year investments that the mandate allows, believing that all the expected interest rate hikes over the next year have been priced in for now.

Tania Miglietta
Portfolio Manager

Cash has outperformed bonds so far this year as bonds extended their losses into the second quarter. The All-Bond Index (ALBI) was down 3.6% for the period, taking its year-todate loss to just over 2%. While cash was up 1.8% in the quarter (3.6% year-to-date) and inflation-linked bonds up 0.6% for the quarter (3.3% year-do-date).
The sell off in the bond market was led by a number of factors, principally the reduction in risk appetite for emerging market assets that we had expected would eventuate sometime this year. The trigger point seemed to be the US Federal Reserve raising interest rates beyond where many had expected, coupled with expectations of further monetary tightening by both the European Central Bank and the Bank of Japan. Rising interest rates both reduce general liquidity available in the market - usually meaning a fall in risk appetite - and also raise the relative return required by other assets if they are to continue to remain attractive.
Local bonds were affected by a general sell off in emerging market debt, but seemingly more so by the fall in the rand that accompanied lower risk appetite. At the time of writing, the trade-weighted rand has lost some 18% since late April. The cherry on top for the bond market was the SA Reserve Bank's move to raise the repo rate by 50 basis points to 7.5% at the June Monetary Policy Committee meeting. While the FRA market had discounted some probability of a rate rise, it seemed that the fixed interest market was to a large extent caught unawares by the move. A worse than expected current account deficit for the first quarter subsequently sent jitters through the market, opening the possibility of further rises of the SA repo rate. We have for some time expected that interest rates would enter an upcycle this year and thus were positioned for the market moves. At present we expect the SARB to raise interest rates another 100 basis points by February 2007.
An interesting development in the domestic market was a change in sentiment towards credit, where the previous "buy at any price" attitude towards new corporate credit received a shock when buyers weren't as prevalent as before. We have for some time believed that credit pricing did not justify the risks and that it made sense to hold only fairly-priced high-quality issuer names. Investors will recall that for the Coronation Money Market Fund we only invest in assets assigned either an F1+ or F1 rating, the two highest ratings.
The portfolio has held a high proportion in floating rate investments which provides a buffer against rising interest rates as the underlying yield resets with a change in the Johannesburg Interbank Average Rate (JIBAR) or prime rates which in turn follows the repo rate closely. Thus the fund's yield automatically adjusts upwards if underlying interest rates in the market rise.
While we had been defensively positioned in the run-up to the repo rate hike, we feel that the money market is now starting to offer value in areas which fully price in our interest rate expectations over the next 12 months.

Tania Miglietta
Portfolio Manager

Short-term interest rates in South Africa have been remarkably stable at historically low levels for over a year supported by a stable currency and inflation which has remained well within its target range.

The US Federal Reserve hiked the Fed fund's rate again, by 25 basis points taking it to 4.75%. With prospects for further hikes the US base rate is likely to reach at least 5% sometime soon. Ten-year US treasury bonds have finally responded to the ongoing interest rate hikes in the US by weakening in yield to close to 5% at the time of writing. We note that the differential between SA 10-year and US 10-yearyr bonds is now around 2.6% - with inflation differentials around 2.25% that does not leave much for souvereign risk.

Short-term interest rate differentials of 2.25% are also at unprecedented levels, and are especially remarkable given the difference in credit quality between the two countries.
Twelve-month money market rates yielding 7.30% are pricing in a small probability that the repo rate may be hiked within a year. This is consistent with our view that the South African Reserve Bank may need to do so given the strength in demand of the SA consumer. Inflation has been surprisingly stable even in the face of rising oil prices and should still remain within its target range if the currency remains as strong as it has. Volatility in fixed interest markets is exceptionally low which means that market movement is very subdued making trading opportunities few. As a result returns remain stable but low by historical standards. A portfolio manager would need to take on a lot more risk to increase returns, which in the case of this fund, would be imprudent given its very low risk nature.

The Coronation Money Market Fund has been positioned for a flat interest rate scenario for some time, given the fund's shortterm interest rate focus. Even if interest rates were to be hiked sometime in the future, this would only affect the fund closer to that time and fund duration would be adjusted accordingly.

Tania Miglietta
Portfolio Manager

The year 2005 will be remembered as the year that the rand remained relatively stable, with a lower than expected inflation rate and the year in which interest rates ground even lower. Lower interest rate volatility set the tone, with bonds trading for long periods of time in very narrow ranges. Higher levels of uncertainty leading to less trading activity and neutral positioning by fund managers tended to dampen the market. Foreign investors were evident in our market. They favoured local currency as opposed to foreign listed bonds showing their willingness to take on emerging market currency risk in their ongoing search for yield. As it turns out, emerging markets' bonds and equities were by far the best performing asset classes globally.
Money market yields remained stable all year with minor fluctuations at times mostly based on currency movement. The 12-month NCD ranged between 7.10% - 7.50% all year. The money market yield curve remains flat, indicating that short-term interest rates are likely to remain unchanged for the next year - a rare occurrence in the SA market. Should the currency remain where it is, this could be the case however.
The Coronation Money Market Fund returned 7.0% net of fees during 2005 and 1.6% for the last quarter of the year. This compares with 7.0% and 1.6% from the 3-month STeFI benchmark respectively. This is a healthy outperformance from a very conservative fund. The portfolio duration was increased in November when it became apparent that interest rates would not rise aggressively as inflation was likely to remain contained for longer.
The market has become cash flush which has put additional pressure on interest rates to fall. This is backed up by the FX forward curve which shows that SA short-term rates could still fall further this year if the rand/US dollar exchange rate remains this strong.
Looking forward, both global and domestic backdrops are likely to remain benign for SA interest rates. Our strategy for the year includes identifying the remaining well-priced yield opportunities, being cognisant of the risks, and noting where South African interest rates have come from and how expensive many of these assets have become.

Tania Miglietta
Portfolio Manager