The Coronation Bond Fund produced a return of 1.11% over the past quarter, which was basically in line with the All Bond Index (ALBI) return of 1.10% and behind that of cash at 1.71%. The fund return for the year to date at 5.88% is ahead of the ALBI return of 5.48% and that of cash at 5.34%.

The star performer in the fixed interest universe this year has continued to be inflation-linked bonds (which are not included in the ALBI). The Barclays SA Inflation-Linked Bond Index returned 14.05% in the year to September, with the long dated R202 (maturing 2033) returning an impressive 20.2% year to date. Real yields on linkers have continued to fall, while breakeven inflation has risen. Demand for linkers as protection against rising inflation as well as new product specific demand, has been the main driving force behind the fall in real yields. The fund benefited from exposure of around 6.5% to inflation-linked bonds.

The bond market just managed to eke out a positive return in the third quarter. Despite the strength early in the quarter where the benchmark R153 traded to a record low of 7.36% ahead of the August Reserve Bank Monetary Policy Committee (MPC) meeting, we saw bond yields kick up as the MPC left the repo rate unchanged and a rampant oil price fuelled inflation fears.

Looking at the yield curve, the 7 - 12 year area of the curve was the top performing sector over the quarter, providing a return of 1.49% with the government R203 (2017 maturity) and R204 (2018 maturity) performing particularly well.

The fund's exposure to corporate credit remains at a relatively conservative 15% as we feel that the compression seen in credit spreads seems to have run its course. During the quarter we established a position in the Liberty corporate bond, which we believe showed good value at issue at 120 basis points over the benchmark government bond and, at the same time, we exited our position in Denel bonds over concerns of the financial viability of that entity, despite it being government-owned.

Despite some renewed inflation fear, the market still held up well. It was supported by a relatively good performance from the rand (helping mitigate concerns about inflation), as well as a continued largely sideways movement in US Treasuries. While the US Federal Reserve Bank (Fed) has continued raising US interest rates, it is noteworthy that the Fed recently released a study indicating that foreign investment in the US bond market has seen 10-year bond yields at levels 100 to 150 basis points below where they might otherwise be expected. Because SA bonds, like most bonds internationally, are effectively priced off US yields, this has had a dampening effect on bond yields globally, including SA.

We have for some time held the view that official interest rates are likely to rise in 2006. CPIX (inflation excluding mortgage interest rates) is beginning to pick up, from a low of 3.1% in February 2005 to 4.8% in August, as the weakness in the rand this year and higher petrol prices start taking effect.

Food price inflation has remained very low, and this has helped offset the effect of rising petrol prices (CPIX excluding food was at 5.5% in August). We see inflation rising further next year, likely sailing close to the top of the Reserve Bank's 3% to 6% target range for CPIX. There is a chance that it will breach the top of the target range. Factors (other than the petrol price) that may see this happen include a less benign food price environment (maize futures prices have risen sharply in recent months), rising global inflation (affecting imported inflation) and a potentially weaker rand. There will be further pressure on input prices from above-inflation wage increases this year. With consumer spending so strong, there seems little incentive for retailers to try absorb a rising cost base into their margins. We thus still expect that cyclical pressures on inflation will probably see interest rates rise next year, but that this (especially compared to historic standards) will be contained, probably at between 1.5% to 2%.

We reiterate that our bearish view on inflation is a short-term, cyclical view, and that the structural improvement remains in place. But we emphasise that while we believe SA has in general moved into a structurally lower inflation environment, we cannot ignore the fact that inflation will still exhibit cyclical movements.

US yields remain the most important factor in determining SA yields, and thus a continuation of the low yield environment that we have seen will be supportive for SA bonds. While US bond yields have certainly surprised on the low side, we still expect some increase in yields based on economic fundamentals (though the extent will likely be mitigated by continuing capital inflows to the US Treasury market from Asia). We also anticipate that the global backdrop for emerging markets - incredibly favourable at present as it rides high on a wave of risk appetite - will deteriorate somewhat as the Fed continues to raise rates, reducing liquidity and raising the relative "risk-free" rate of return.

Thus, our overall view remains one of some further weakening in the bond market, due to inflation being in an upward cycle, US bond yields rising further, global risk appetite reducing, and some higher supply.

Currently we maintain a short bias in the fund relative to the ALBI, with a fund modified duration of 3.5 (excluding inflation-linked bonds) versus a modified duration of 4.95 of the ALBI. Our exposure is predominantly in the short and medium dated area of the curve, avoiding the long end as we do not feel that we are being sufficiently compensated in yield for the capital risk taken in the long end.

Mark le Roux
Portfolio Manager

The Coronation Bond Fund showed a return of 4.4% over the past quarter, marginally behind the All Bond Index (ALBI) return of 4.7%, and ahead of cash at 1.9%. The fund return for the year to date at 4.7% is still marginally ahead of the ALBI return of 4.3%, and both marginally ahead of cash at 3.8%.
The best performing section of the yield curve for the year to date was the 7-12 year area, which returned 4.9%. However, the star performer in the fixed interest universe this year has been inflation-linked bonds (which are not included in the ALBI). The Barclays SA Inflation-Linked Bond Index returned 9.6% in the year to June, with the long-dated R202 (maturing 2033) returning an impressive 12.1%. Real yields on the bonds have fallen significantly this year (underpinning their price), while breakeven inflation - the implied expected inflation rate calculated by comparing inflation-linked versus nominal bonds - has risen. This appears to be partly due to heightened inflation concerns as the rand weakened during the second quarter. However, the good performance of inflation linkers also appears to be a reflection of a continuing imbalance in the market as demand continues to grow faster than supply. The fund benefited from exposure of around 7% to inflation-linked bonds.
Positive performance from bonds in the second quarter was due to a number of factors. The kick-start, early in the quarter, was another surprise repo rate cut (by 50 basis points to 7.0%) delivered by the Reserve Bank at the April Monetary Policy Committee meeting. This also led to a tandem move down in the R153 of about 50 basis points. The yield curve was also steeper in the second quarter compared to the first, which could be ascribed to a combination of some inflation fears creeping in as the rand weakened, as well as the fact that most of the new supply coming into the market from government is at the longer end of the yield curve. Since the beginning of the current fiscal year in April, about 75% of government auction amounts have been in the 12 years and longer sector of the curve.
The other important factor in keeping yields low despite rand weakness was further downward moves in global bond yields. While the focus is usually on the US, it is also worth noting that German bonds reached record low yields during the quarter. Federal Reserve Chairman Alan Greenspan has described the low bond yields in the US as a "conundrum", and there have been a number of explanations put forward as to why bond yields seem to defy the economic realities in the US - where growth is still reasonably strong and the Fed still raising interest rates. The most appealing explanation appears to be linked to high savings rates in Asia being recycled into purchases of US Treasuries where, although yields are low at just over 4%, they are still well above Japanese 10-year yields of around 1.3%.
We continue to hold our relatively bearish (compared to consensus) views on the rand and inflation over the shorter term. While the movements of the rand in the second quarter were largely in line with our view (albeit materialising a bit sooner than expected) and thus leave our year-end forecast of R/US$6.95 intact, there are still many market participants expecting a retracement to stronger rand levels. These differing views have different implications for inflation, and we see a good chance of CPIX breaching the upper limit of the 3% - 6% target early next year. As such, we think any further rate cuts are highly unlikely (the FRA market is still discounting a chance of a rate cut later this year) and, indeed, rate rises may happen sooner than the market thinks.
While recent moves in the oil price will certainly help push inflation up, our concerns about inflation stem more broadly from a very robust economy, which no longer has the advantage of a continuously appreciating rand to offset incipient demand-led inflation pressures. These include very robust consumer spending, high growth rates in money supply and credit (household credit is growing well over 20%), and continued pressure on the current account as a result of the strong rand and low interest rates.
We reiterate that our negative view on inflation is a short-term, cyclical view, and that the structural improvement remains in place. But we emphasise that while we believe SA has in general moved into a structurally lower inflation environment, we cannot ignore the fact that inflation will still exhibit cyclical movements.
Another factor that will affect the bond market is supply. While data for the fiscal year so far already show revenue collections that may lead to a reduction in government supply, it remains the case that government supply of bonds will be higher than was the case a few years ago. Moreover, there will be significantly increased parastatal issuance to help fund the announced investment programmes; Eskom has already announced a R5 billion domestic market issue will take place, and other issuers (such as the Trans-Caledon Tunnel Authority) continue to tap the markets. Finally, corporate issuance (including securitisations) is expected to remain strong. It is thus clear that the supply picture has turned from being supportive to being a source of some pressure for the market. This is especially so given that recent fund manager surveys indicate that bonds are the least favoured asset class this year, implying that the demand picture will not be particularly strong.
US yields remain the most important factor in determining SA yields, and thus a continuation of the low yield environment that we have seen will be supportive for SA bonds. While US bond yields have certainly surprised on the low side, we still expect some increase in yields based on economic fundamentals (though the extent will likely be mitigated by continuing capital inflows to the US Treasury market from Asia). Moreover, we expect that the spread between SA and US bonds - which has already widened about 70 basis points since its low in late February - will continue to widen as domestic fundamentals for the bond market, as described above, worsen.
Thus, our overall view remains one of some further weakening in the bond market. With inflation expected to turn upwards, US bond yields to rise further, global risk appetite to reduce, and a higher budget deficit leading to higher supply we expect bond yields to move higher over the course of the year.
On this basis we will be maintaining our stance of an underweight duration to bonds, with a fund modified duration (excluding inflation-linked bonds) of 2.9 years, compared to a modified duration of 5.0 years for the All Bond Index.

The Coronation Bond Fund outperformed the ALBI by 1.56% for the month of March and 0.59% for the first quarter of 2005.
Although the bond market started the year off by extending the rally seen in the second half of 2004, even reaching record low yields in February, March saw a change in sentiment in the market. The extent of the sell-off in bonds saw the All Bond Index (ALBI) lose 3.7% in that month alone, dragging the overall first quarter ALBI performance into the red at -0.3%. The move seen was a bear steepening, i.e. the longer end of the yield curve fared the worst. In fact, the 12 years and over sector of the yield curve declined by some 7.7% during the month, bringing the first quarter performance for that sector to -1.7%. However, the shorter end of the yield curve was protected, with both the 1-3 and 3-7 year sectors returning a positive 0.2% over the quarter. Still, those returns far lagged cash which returned 1.9% over the quarter.
A number of factors led to the weaker performance in the bond market. While some in the market had expected a repo rate cut at the February Monetary Policy Committee (MPC) meeting which did not materialise, we believe the more important factors were the same ones that supported bonds in the second half of last year, namely the global backdrop. In this instance, though, the global background is now less supportive. Most indicators of risk appetite worsened through March, led by a rise in US bond yields and upwardly revised expectations of the path of short-term US interest rates this year. These undermined emerging market bonds in general, as well as the rand. The latter's depreciation, coupled with a renewed rise in international oil prices, has led to investors looking past current good inflation data and towards rising inflation from March.
A change in global risk appetite as well as a reduction in market complacency regarding domestic inflation are risks to the bond market that have concerned us for some time and the driving reason why we used strength in the bond market in the last quarter of 2004 as well as first two months of 2005 to reduce the modified duration (interest rate risk) of the fund. The bond market became so expensive on a fundamental basis towards the end of February that we took the duration of the fund as low as two years short of the ALBI (the benchmark for the fund). Given the subsequent retracement in yields to higher levels during March, we have increased the duration of the fund slightly (to 1.75 years short of the benchmark) but have utilised call options to achieve this portfolio change as we are concerned about capital risk should bond yields continue to rise.
The outlook for bonds is still risky given a backdrop of rising South African inflation as well as uncertainty regarding the pace of increase in US interest rates which will leave risky assets such as emerging markets vulnerable. Our investment stance within the fund is thus still conservative with an emphasis on low capital risk until the bond environment becomes more favourable. Once yields have reached levels which we feel to be fairly valued given these risks, we will look for levels to increase the duration of the fund as well as exposure to the longer dated end of the yield curve.

Positive sentiment reigned in the last quarter of 2004 with a strengthening rand resulting in the market becoming increasingly optimistic on the outlook for lower interest rates and inflation across the yield curve. A positive global environment with high risk appetite remained in place throughout the quarter which fuelled further search for yield and continued to provide a favourable backdrop for emerging markets spreads and higher yield currencies such as the rand. These developments allowed bond yields to continue to fall, with the R153 government bond, maturing in 2010, rallying from 8.81% to 7.82% throughout the quarter.
Although we agree that the inflation outlook has improved with the extended rand strength, we feel that the market is currently pricing in an inflation outlook that is too optimistic. One way to measure this is by analysing the difference between nominal (i.e. fixed rate) bonds and inflation-linked bonds (which are linked to movements in inflation). The difference between these is known as breakeven inflation and is a good proxy for current market inflation expectations. Currently breakeven inflation for a bond maturing in three years time is approximately 3.75%, ie, only if inflation is lower than 3.75% over this term will nominal bonds outperform inflation-linked bonds. Although we think that inflation, based on our central forecast, is likely to remain within the 3% - 6% target band over this three year period, we currently project that the inflation rate will be closer to the upper end of the band by this time next year.
Although cash rates for a 12-month fixed term are low at 7.35%, the R153 yield can only afford to rise to 8.00% (i.e. 18 pts) before it will start to underperform this cash rate. This is a very small margin given a situation where bond yields are priced for substantial good news, leaving them increasingly vulnerable to disappointment.
From a global perspective, higher interest rates in the US are likely to have a number of consequences for SA bond yields. Firstly, we expect longer dated US bond yields to rise over the course of the year as global growth remains reasonably healthy and the market prices in further interest rate increases. Higher US bond yields have historically led to higher SA yields. In addition, low US interest rates have provided a substantial degree of liquidity and fuelled global appetite for risk which has significantly benefited higher yield investments. This trend has been in place for some time and is clearly at risk as US interest rates continue to rise.
Although further short-term gains in the rand may be possible, we are becoming increasingly concerned about the sustainability of financing the reasonably large current account deficit which is at this stage being funded to a large extent by short-term investment flows. A reduction in global risk appetite will remove this underpin and leave the rand vulnerable. These are risks that are not currently being priced into domestic bond yields.
Given this backdrop, our strategy over the coming quarter is to remain defensively positioned, keeping the modified duration (a measure of the capital risk) of the fund shorter than that of the index (currently almost a year shorter than the index), to protect against capital loss should bond yields begin to rise off their current extremely low levels. We will continue to build on positions such as inflation-linked bonds which will protect the portfolio should inflation and interest rates surprise on the upside throughout the year.
Our investment in corporate bonds within the fund has continued to perform strongly throughout the quarter, with the spread to government bonds of a number of the corporate bonds compressing quite substantially. This has occurred due to the current low level of yields which has spurred significant investor appetite for yield enhancement. A number of corporate bonds are starting to reach expensive levels and we have begun to take profit on some of the exposures. We will continuously monitor these exposures and take further profit on counters when they become overvalued.