During the course of the quarter the funds remained underweight on duration, based on the fund managers pessimistic view of inflationary developments. Furthermore, while inflation was forecast to rise from around 6% at the end of 2001, to peak at over 11%, bond yields have risen from around 10% in November 2001 to barely above 11% by July 2002.

In the context of a deteriorating inflationary outlook then, bonds offered very little value, unless one was extremely confident about future inflation declining sharply. It was becoming increasingly unlikely that inflation will fall into the targeted range for either 2002 or 2003, and hence the fund managers view that substantially higher bond yields were required before they could be considered to be cheap.

Ultimately, this view proved to be correct, but the upward move in yields continues to be constrained by a supply squeeze in the market. While the inflationary outlook does show inflation declining somewhat during 2003 (but still missing the target) the supply situation will also begin to normalise at the same time. Therefore, strong moves lower in yield are not expected. A conservative approach to portfolio structure will be followed.

At the beginning of the second quarter, the fund was short in duration relative to the All Bond index. At that time, the fund manager's view was that a substantially higher yield on local bonds was required to compensate investors for the degree of uncertainty regarding inflation. Initially, as yields rose, this was the correct strategy.
However, during the quarter two developments caught the fund manager's by surprise. Firstly, the entrance and number of foreign investors into the local bond market, after an absence of almost two years. Secondly, the unusually large purchase of R186's, the ultra-long 24-year bond. This was on local demand, thought to be as a result of one or more large life assurers correcting asset mismatches on their long-term annuity liabilities. The result of these two forces saw yields drop almost 150 basis points before settling into a broad sideways consolidation for the remainder of the quarter.
While the fund manager's view on inflation has been correct, and in fact has surprised the market in general, the supply-demand imbalance has had far greater impact than the fund manager's expected due to the aforementioned factors.
For the quarter, the fund underperformed its benchmark due to having followed too conservative a route over the period.

In January 2002, the Reserve Bank surprised the market with a 1% hike in interest rates. This was largely driven by the impact on inflation caused by last year's Rand depreciation, and more importantly the impact on inflation expectations. These expectations had increased substantially and have to moderate if the Reserve Bank is to meet its 2003 target. Already it is clear that the 2002 target will not be achieved. Again in March, the Reserve Bank raised rates, citing identical reasons.
Over the quarter, the fund manager continued to see weakness in the bond market with the R153s ending at 13.20%. Furthermore, he saw a flattening of the yield curve. This is often indicative of an environment in which investors expect little or no growth and inflation to remain under control.
Internationally, the global economy looks set for a strong recovery this year. Already, markets have started to price in rate hikes by as early as the second quarter. However, the fund manager does not believe that the global recovery is guaranteed, particularly if oil prices remain at high levels. Furthermore, global inflationary pressures continue to remain muted providing no urgent need to raise rates. Thus, the fund manager anticipates that the major central banks will only start to increase rates in the third quarter. This backdrop provides very little support to bond yields internationally.
Locally, the market expects at least one more interest rate hike in June. The possibility of further increases during the year will depend upon whether inflation continues to surprise on the upside, and on whether inflation expectations remain high.
Inflation is only likely to peak in the third quarter of the year. Until then, bond yields are expected to trade weaker. The absolute levels will continue to be constrained by the lack of supply of paper in the market. Once again, the quarter presents low expectations of capital gains, with the focus on opportunistic type gains with consistent income levels.

The Coronation Specialist Bond Fund has won the S&P 2002 award for the best fund within the Domestic Fixed Interest Bond sector over a one year period.

Over the past year bonds have outperformed equities for a number of reasons. This outperformance has resulted in the Coronation Specialist Bond Fund delivering returns in excess of 29% for the year to 30 September 2001. Although it is anticipated that returns over the next 12 months will be lower the prospect for bonds continues to be positive.