Investors witnessed wild swings in interest rate expectations this quarter, influenced by uncertainty on the global front as well as slowing economic growth which was not anticipated early on in the quarter. In July, the Forward Rate Agreement (FRA) curve predicted that short-term SA interest rates had bottomed with the first rate hike expected in March 2012. This picture changed quickly on poor second quarter GDP figures, comments by the SARB Governor Gill Marcus in August that the SA economy remains fragile, ongoing unemployment worries, slow capital investment and a low export recovery. This statement by the SARB lead to a swing in the interest rate outlook to now price a 40% chance of further repo rate cuts in early 2012, with the first hike pushed out by another year to March 2013. Inflation printed at an unchanged 5.3% year on year for August, thus remaining within the target band of 3% - 6%. The rand/dollar exchange rate weakened by as much as 15% during September, which has implications for higher inflation should the rand's weaker tone be sustained. We already expect that CPI will breach the target by the fourth quarter of this year, since the recent rand weakness will have an immediate impact of higher fuel prices and with a lag, higher food prices, but most of the move will feed through to next year's inflation data. Should the rand's current levels be sustained, and in the absence of any significant downward move in global commodity prices, the risk of a later and higher peak in CPI is a very real one. Should the rand/dollar exchange rate remain above R8.25, we expect inflation to rise to as high as 7%, with little prospect of returning to within target range next year.

Money market rates are at an all-time low and investors seeking yield from this asset class will have been feeling the pinch for some time now as interest rates have ground lower.

Prospects for higher interest rates in the future are inevitable as interest rates are cyclical and inflation is set to move ever higher, bringing on the need to raise interest rates. However, we do not expect interest rates to rise any time soon given the concerns about economic growth and poor job growth. The portfolio has remained fully invested in top quality money market instruments during the quarter mostly made up of bank issued paper, with a 12% holding in government guaranteed Treasury Bills which are not only of superior credit quality but for much of the year have provided a better yield than 3 month NCDs. Corporate credit makes up 30% of the fund in quality names such as Bidvest, Netcare, Liberty and Mercedes Benz SA.

The fund is managed with the objectives of achieving full liquidity, capital protection and a good yield, thus we do not take on undue risk and do not invest in credit which in our view is opaque or mispriced. The fund achieved a total return for the last 12 months of 5.8% versus wholesale money market call rates which have yielded 5.2% p.a. since November 2010, and the 3 month STeFI, the fund's benchmark which returned 5.6% for the last year.

Portfolio manager
Tania Miglietta

The fund returned 1.4% for the quarter and 6.1% for the past 12 months.

Interest rates are at an all-time low, with the repo rate having been at 5.5% since November 2010. Issuance in the money market has been plentiful but at much tighter spreads than a year ago. New names have entered the market, amongst them Scania and Pick n Pay which made a debut in the CP market this quarter. However, we were not participants due to the low yield at which they were issued. The focus in this interest rate environment is to correctly price for credit and to be selective enough as, should the cycle turn quickly, spreads are likely to widen again. We do not invest in instruments rated less than F1, thereby keeping the credit quality of the fund at better levels. Local inflation data continued on its upward trend, with May CPI at 4.6%, now above the midpoint of the South African Reserve Bank's inflation target range. We expect that CPI will approach the upper end of the target range of 6% by the end of the year. With inflation heading higher, negative real short-term interest rates appear to be on the cards unless the South African Reserve Bank elects to start raising interest rates sooner. We are of the view that interest rates are too low and that they should be raised this year in order to keep inflation in check.

The fund is structured to be fully invested in its quota of SA bank floating rate notes, with a growing holding in SA Government Treasury Bills and SARB debentures. Lately the government-guaranteed instruments have been offering better value than some bank NCDs and have thus gained a renewed following from money market funds. Corporate issuer names such as Bidvest, Mercedes Benz, Barloworld, Aspen Pharmacare, and Group Five represents approximately 9% of the fund, providing some yield enhancement. However, we view credit in the money market as being largely overpriced, and thus are waiting for better value in the form of higher spreads over JIBAR before increasing it to a preferred 20%.

Portfolio manager
Tania Miglietta Client

The fund returned 6.52% for the 12-month period to end March 2011 compared to the 3-month STeFI benchmark which returned 6.18%. The fund has been at a 90 day duration during this period of declining interest rates.

One-year deposit rates have fallen significantly to a new low of 5.95% from their last peak in mid-2008 of 14%. The long-term chart of the one-year NCD below shows the series of interest rate cycles experienced in SA since 1986. It is clear that new lows have been achieved over time as average inflation levels have moved down. The FRA curve is factoring in a 3% interest rate rise over the next two years, based on the view that inflation is expected to head towards 6% over the next year.

We have favoured the use of floating rate notes which on average provide a yield pick-up of 0.7% over prevailing money market rates. This strategy will prove to be useful as interest rates start to rise, giving the portfolio a hedge against rising interest rates.

We keep a careful check on the quality of corporate credit introduced into the fund. Corporate credit refers to anything not government guaranteed, meaning that you rely on the financial soundness of the company to ultimately repay the capital and interest owing on maturity. Typical names included in the fund are MTN, Transnet, Eskom, Aspen Pharmacare, SABMiller, ACSA, Unilever, Mercedes Benz, Bidvest and Barloworld. These are well established, financially sound businesses and parastatals.

We are big believers in the ultra conservative stance needed when dealing with investors' cash assets and therefore whilst being selective of the name, we are particularly strict on pricing and demand a suitable yield pick-up over the risk-free rate for each instrument we consider. Simply speaking, if it's not the right yield pick-up for the name, we do not participate.

Given the banks' extensive involvement in the money market it should come as no surprise that the largest exposure in the fund is to the big four South African banks. This should be the case in any conservatively structured money market fund. These instruments are highly liquid, ensuring that the fund can be disinvested at short notice.

Portfolio manager
Tania Miglietta Client

The fund returned 6.9% during 2010. This was ahead of the STeFi cash benchmark which returned 6.6% for the year.

This portfolio, the most conservative of the fixed income range of funds, has maintained a 90 day duration throughout the year as interest rates have declined. It also participated in 12 month floating rate notes at attractive spreads over Jibar (Johannesburg Interbank Average Rate), TBs (Treasury Bills) which became cheaper than bank NCDs during the year as well as corporate paper. The fund is a blend of the best quality short-dated money market assets available. We do not invest in instruments rated less than F1.

During late November the South African Reserve Bank announced a further 0.5% repo rate cut taking it to an all-time low of 5.5%. We are however concerned about a potential upward move in inflation this year and believe that ongoing interest rate cuts will further spur this on. We note that the last two CPI inflation readings have come in worse-than-expected (even though the absolute level is still low at 3.6% in November), yet interest rates are still being reduced. Breakeven inflation derived from the shorter end of the inflation-linked curve (2013 and 2017 maturities) remains near the top of the inflation target range at over 5.7%, indicating that the market is expecting inflation to average this figure over the next number of years. We do not believe there is further scope for cutting interest rates. In fact, should any further repo rate cuts materialise, we would take that as another negative for the longer-term inflation outlook.

At this point in the interest rate cycle money market yields are at 30-year lows and therefore proving to be a problem to those relying on pure interest income from money markets. 3- month Jibar has settled at around 5.55% and with 3-month TBs yielding more at 5.65% and R155 bonds at 5.85%, government guaranteed assets offer good value to the money market. The fund is conservatively managed with only the best credits being selected for this low-risk portfolio. We therefore welcome the introduction of these cheaper-than-usual government guaranteed assets as they serve to further reduce the risk of the overall fund.

Looking forward, in this low interest rate environment we seek to achieve a steady long-term outperformance of our benchmark Jibar. However, the current low level of interest rates needs to be taken into account with regards to overall yield expectations.

Portfolio manager Tania Miglietta