The fund generated a return (net of management fees) of 5.63% 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 three-month period. 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 have been 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. 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

The fund generated a return (net of management fees) of 5.27% for the rolling 12-month period, ahead of the 5.23% delivered by the 3-month STeFI benchmark.

Fixed interest markets extended their positive run into the second quarter of the year, with the All Bond Index (ALBI) gaining 2.5% for the quarter, inflation-linked bonds (ILBs) gaining 5.9%, and cash lagging with a return of 1.45% over the period.

Short rates pulled back from beginning-of-the-quarter levels, with 3 - 5 year fixed bank rates down on average 20 basis points (bps) over the quarter. Yet the 1-year fixed bank rate pushed up 13bps and floating-rate spreads pushed up 7.5bps over the period as banks had appetite for 1-year funding. The fund took the opportunity to participate in the 1-year floating rate notes linked to prime.

Forward rate agreement (FRAs) rates, which serve as an indication of future repo rate movements, remained relatively flat for year one, but pulled down an average 25bps for the second year. This indicates that market expectations for repo rate moves in the coming year (100bps in hikes) have not changed, whereas expectations are now for a further 75bps uplift after two years compared to the 100bps in hikes that were previously expected.

The rand weakened slightly during the quarter to close the period at R/$ 10.64 (compared to R/$ 10.53 at the end of the first quarter). This came despite foreign bond inflows of R13.8 billion during the quarter - a reversal from the R28.6 billion in outflows recorded in the prior quarter.

Local events and data releases were at best mixed. While the current account deficit for the first quarter showed a surprise narrowing to 4.5% of GDP, the reason behind the compression (large foreign dividend receipts) is probably a once-off, and suggests that the deficit is likely to widen again. The trade account remains in deficit territory, with the year-to-date deficit already R13 billion wider than that of the comparable period in 2013. While the resolution of the five-month long platinum strike is encouraging, it may take a few months before full production is restored. Coupled with the strike in the metals and engineering sector, the outlook for the current account in the near term is not comforting.

Standard and Poor's (S&P) downgraded the SA sovereign (foreign currency) credit rating to BBB- (one notch above subinvestment grade) and moved the outlook from negative to stable. S&P notes that the current rating and outlook reflect the adverse local fundamentals; therefore limiting the risk of further downgrades by the agency. The local currency rating, used for World Government Bond Index (WGBI) inclusion, sits at BBB+ (two notches above the foreign currency rating and three notches above sub-investment grade). Fitch, on the other hand, affirmed its rating at BBB (one notch above S&P), but changed its outlook to negative. It is not inconceivable that Fitch could downgrade SA to bring it in line with S&P's rating over the next year or two, especially if signs of fiscal consolidation do not strengthen by the time of the Medium-Term Budget Speech (MTBPS) in October this year or that of the Budget in February 2015.

The South African Reserve Bank (SARB)'s Monetary Policy Committee (MPC) again kept the repo rate unchanged in May. However, the MPC re-iterated that SA is in a tightening cycle, so further rate hikes are likely. With May's inflation print at 6.6%, the SARB's credibility will likely be a consideration when the MPC meets on 17 July. Though inflation expectations were unchanged in the Bureau for Economic Research (BER)'s second quarter survey, increasing headline inflation will likely filter through to expectations in coming quarters, and the SARB could move ahead to contain expectations. However, given the weak growth backdrop, the hiking cycle should be a moderate one (a point the SARB has been at pains to emphasize). Furthermore, the MPC has also communicated that the pace of tightening will take into account policy normalization in developed markets; with the US Federal Reserve only expected to start hiking rates in the second half of 2015, hikes by the SARB are unlikely to be front-loaded, nor sizeable. The fund continues to seek good yielding opportunities, but with the key objective of providing capital preservation and liquidity.

Portfolio managers
Mark le Roux and Nomathibana Matshoba

The fund generated a total return (net of management fees) over the last 12-month period of 5.13%, 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 of both the All Bond Index (ALBI) and inflation-linked bonds lagging cash.

Bank one-year fixed-rate NCDs ended the quarter 5 basis points higher, 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 in 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 on the timing thereof, tapering was finally announced in December 2013. From January 2014, the Fed will reduce 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 shortterm rate hikes. In essence, while the Fed allowed long-term rates to drift higher, it stated that short-term rates would remain lower for longer if 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.

For the fund, we have adapted a barbell approach, in which we increased investments in 2 - 3 month and 12 -13 month instruments. This, we believe, is the best approach to enhance yield. We continue to seek attractive yielding opportunities, but with the key objective of capital preservation and liquidity.