The bond market continued to provide reasonably healthy returns during the quarter, although the pace of the rally in bond yields has slowed somewhat from previous quarters.

A number of factors have been supportive of the downwards trend in bond yields. Inflation showed further improvement during the quarter with CPIX falling to just above the upper end of the Reserve Bank's 3% to 6% target range. Following the 1.5% cut in the repo rate in June, interest rates continued to fall, with the repo rate being cut a further 2% over the quarter. The downwards move in interest rates was largely discounted by shorter dated bond yields which fell quite noticeably during the quarter, resulting in a steeper yield curve.

The currency showed further gains throughout the quarter, despite the fall in interest rates, and was supported by a positive environment for emerging markets in general. International bond yields, although losing ground earlier in the quarter, recovered somewhat towards the end of September and remain at relatively low levels.

Although the bond market is likely to remain reasonably well supported over the short-term, bond yields are discounting a great deal of optimism and are approaching levels where the fund manager's feel they would, at best, be fairly valued. The risks of a possible deterioration in international bond yields, a cyclical upturn in inflation to slightly higher levels and an increase in the supply of Government bonds, could undermine strength in the bond market (particularly for longer dated yields) over a longer term time horizon. Given this backdrop, the fund manager's intend to adopt a cautious stance to the management of the fund at this stage.

The fund manager's maintain that a core component of the fund should be allocated to high quality corporate bonds which provide an attractive yield enhancement to the portfolio, but continue to manage credit risk in the fund within tight parameters.

The past quarter has proved to be an exciting one for the bond market as the improved inflation outlook and stable currency pushed bond yields to unprecedented levels. The global bond environment has provided a healthy backdrop to the domestic market with international yields falling on fears of global deflation and uncertain growth prospects, coupled with further cuts in already low short-term international interest rates.

Bond yields (both domestically and offshore) should be viewed somewhat cautiously going forward as a great deal of optimism is already factored into yields at current levels. The global bond rally has certainly shown signs of vulnerability and, although vast improvements have been seen regarding inflationary pressures in the economy, the risk still remains for inflation to fall more slowly than is currently anticipated (due, amongst other factors, to stubbornly high wage settlements and administered prices).

Given the current risks, the fund manager's have positioned the fund to benefit from a further move down in bond yields. The fund manager's have, however, implemented strategies to protect the fund should a disappointment in inflation, supply pressures and the international bond environment fuel a retracement in yields to higher levels.

The first quarter of 2003 proved to be a particularly frustrating one for bond fund managers. This was due to bond yields moving in a very narrow range for the majority of the period. While yields are now lower than at the start of the quarter, this downward move came largely within the first two weeks of the year.

As a result, the potential to enhance returns through capital gains was fairly limited. Bond yields at current levels have discounted much of the expected good news on inflation for this year, and remain vulnerable to retracement should inflation disappoint on the higher side.

The global environment continues to be supportive for bond investments, given the geopolitical uncertainties and, more importantly, the underlying economic fundamentals. However, global bond yields remain at stretched levels, and continued moves lower will require a renewed and unexpected further deterioration in economic conditions.

It therefore remains a very delicately poised situation for local bonds; the global bond rally is almost certainly close to bottoming out, while local bonds have discounted the good domestic inflation story. So where does the risk lie? Given the uncertainties, both global and domestic, it is evenly split between the upside and the downside. At present, the trend remains down, and the fund is positioned for further moderate downward moves, but given the risks, it is not a time for extreme positions.

The final quarter of 2002 proved to be one in which inflationary forces reached their peak in South Africa. It seems unusual then that the peak in bond yields already occurred in the first quarter of the year. In the context of an increasingly uncertain global macro environment however, a flight to safety was understandable.

Given the levels that bond yields had reached by the fourth quarter, the fund manager's remained cautious in their approach to market risk. In spite of being correct in their inflation views during 2002, this did not add value to the performance of the fund. Unfortunately the fund manager's underestimated the strength of the currency during the last few months and its impact on bond yields.

Although South Africa have only just passed the peak of inflation, bond yields are already not far off their all time lows.

The market is clearly pricing in a substantially better inflation outlook than was generally expected two or three months ago. It is true that the turnaround in the currency should have a substantial impact on inflation, but risks still remain. The trend remains downward however, and moderate risk positions will be appropriate in the short to medium term.