The third quarter of the year saw the bond market come to life with the ALBI delivering a return of 6.90%. This brings the year to date performance to 7.04%. R153s opened the quarter at 9.73% and closed at 8.81%, predominantly driven by a strong rally in the US bond market on the back of lower US inflation expectations and concerns regarding global growth which may result in the Fed raising rates in a gentler manner than had originally been anticipated. This change in market sentiment has also been supportive for emerging markets and risk appetite, hence creating a positive environment for the rand and South African bonds.
South African inflation continued to surprise positively throughout the quarter, with CPIX in August falling as low as 3.7%. This should be the low point in the cycle. The better than expected inflation readings coupled with the strength in the rand for the first half of the quarter prompted an additional 0.50% interest rate cut at the August MPC meeting, providing further support for bond yields.
Given that the low point of the inflation cycle has been reached, and that risks to inflation over the next year have increased as a result of higher oil prices, robust consumer demand and rising vulnerability of the rand to changes in global risk appetite, we feel that bonds at current levels are expensive. We have thus positioned the Bond Fund in a conservative manner, with the modified duration of the fund (a measure of market risk) over 0.8 years shorter than the ALBI index. We have also included an allocation of inflation-linked bonds to the portfolio, which look attractive relative to cash and nominal bonds on a 12-month view. These will also provide an attractive hedge for the portfolio should inflation and interest rates over this period be higher than expected.

Since the beginning of the year bond yields have moved quite significantly higher, driven largely by market concerns over inflation and the SARB's interest rate response. This has been coupled with a move higher in international bond yields as an improving employment picture in the US as well as the emergence of global inflationary pressures has resulted in higher interest rates being priced into US bond yields. Additional pressure on domestic yields came from supply to the market by both the government and corporate sector, which is unlikely to abate throughout the remainder of the year.
Although the bond market staged something of a recovery in June, when the All Bond Index (ALBI) gained 1.1%, bonds as an asset class have now under-performed cash over the last 3, 6 and 12 month periods. For the quarter, the ALBI returned a meagre 0.4% (vs. 2% for cash), and for the year to date 5.7% (vs. 9.8% for cash). Over these time periods, shorter-dated bonds outperformed longer-dated bonds, yet still under-performed cash.
Although the fund manager's concede that the risks to the inflation forecast have receded slightly with the strength seen in the rand, they are still bearish on the cyclical outlook for domestic bond yields. The process of increasing US interest rates by the Federal Reserve is likely to be filled with uncertainty, both regarding speed and magnitude. This uncertainty is likely to result in a measure of volatility in global bond yields. US bond yields have already risen significantly off record lows, and the fund manager's expect that they will continue to rise. History shows that SA bond yields have a close correlation with US yields, and this is expected to be an important factor undermining the market.
A cyclical uptrend in emerging market spreads can be expected as US interest rates rise. With the uncertainty that is likely to prevail throughout this period, one can reasonably expect global investors to reduce their risk appetite and consequently increase the required risk premia for asset classes. This is likely to result in spreads for emerging market risk to move higher over the remainder of the year. This has important implications for the trajectory of the rand, which in turn may begin to place pressure on domestic inflation.
Given this environment, the fund is currently quite conservatively positioned with a relatively short modified duration (a measure of the level of market risk in the fund) but the fund manager's will look to increase the duration as bond yields reach levels where the fund manager's feel they are fairly valued given the risks detailed above.

Effective from 15 Mar 04, the Coronation Specialist Bond Fund has changed its name to the Coronation Bond Fund.

The significant decline in inflation during 2003 to multi-decade lows prompted the All Bond index to provide a very healthy return of just over 18% for the calendar year. The backdrop of a substantially stronger rand and a positive environment for emerging markets and commodity prices continued throughout the final quarter. Momentum in the bond market did however decline, with bonds returning only 2.8% for the quarter.

CPIX fell into the target range during the period and interest rates continued to decline, with a 150bp reporate cut in October and a further 50bp cut in December. The latter was smaller than expected by the market, resulting in shorter dated bonds underperforming the longer end of the yield curve for the month of December.

The corporate bond market saw a great deal of activity in the fourth quarter, with new issues being absorbed relatively easily by the market. The fund manager's are comfortable with the corporate holdings currently in the funds portfolio and, bearing in mind liquidity restrictions, are reluctant to increase the funds exposure to corporate bonds significantly at this stage. The fund manager's have thus kept the funds corporate exposure relatively unchanged throughout the period.

The fund manager's anticipate increasing pressures on inflation during the course of 2004 driven by strong credit growth, some rand depreciation and possible pressures on food prices as a result of prevailing drought conditions. The international backdrop is also unlikely to remain supportive for local bonds with a cyclical upturn in the US economy resulting in US bond yields rising off their currently low levels. Added to these concerns, increased government funding requirements should result in a steepening of the yield curve over the course of the next few months, hence the funds portfolio favouring shorter maturity bonds at this stage.