The bond market staged a rally in September, helping to lift the All-Bond Index (ALBI) to a 3.4% return for the third quarter. This was one of the few times over the past year where bonds have outperformed both cash and inflationlinked bonds. Significant weakness in the bond market in the May - August period is still depressing longer-term returns however, where the ALBI has returned 3.3% yearto- date and 1.6% over the past 6 months, in both instances underperforming both cash and inflationlinkers. The Coronation Bond fund has performed in line with the ALBI producing returns of 3.33% (3rd quarter), 1.76% (6 months), 3.42% (YTD) and 9.20% (12 months).

The SARB raised the repo rate another 50bp in August, bringing it to 10%. While concerns around inflation lingered with a string of worse-than-expected data releases, sentiment started turning after international factors took the lead role. As concerns about the subprime fall-outs impact on financial markets spread - with weak jobs and housing data in the US - the market started to price in a US rate cut. The Federal Reserve duly delivered, even surprising the markets with a 50bp cut at its September 18 FOMC meeting (most analysts had expected 25bp).

The Fed's move reignited interest in risky assets, with SA bonds joining a general emerging markets rally. The dollar has also come under pressure recently, from a combination of the turn in the US rate cycle and the weaker data, and the rand has benefited handsomely from this, once again breaking through the R/$7 level. Given the importance of the rand to SA's inflation outlook, and against a background of near-record highs in global food and energy prices, the currency move is a welcome respite.

While a number of other developed economies have put previous rate hiking cycles on hold in the wake of the Fed's move, not all have - and SA's current inflation situation remains an uncomfortable one. CPIX has been above the upper limit of its 3% - 6% target range since April, and will probably be there until March 2008: representing a full year above the target range. While much of this impetus has been driven by food prices and last year's rand fall, the SARB remains concerned about credibility. One other unnerving factor remains: the current account, where the deficit is likely to stay above 6% of GDP as the (necessary) infrastructure investment programme gathers momentum.

On a longer-term view, however, the big picture is rosier. Even with the lags involved, meaning that we have some months yet to really gauge the effects, it is already clear that consumer spending and consumer credit cycles have turned as the effects of past rate rises start to bite. At the time of writing, the October MPC has yet to take place; while it will be a close call, we think there are solid arguments for leaving rates unchanged. If they do rise again, it should clearly be the peak in the cycle. On the current outlook, we see scope for the repo rate to start falling in the second half of 2008.

Mark le Roux
Portfolio Manager

The interest rate picture took a turn for the worse in the second quarter as inflation data exceeded expectations - notably, CPIX breached the 6% upper end of the target range. The SARB responded by raising the repo rate by 50 basis points in June, having been on hold at the February and April meetings. Pipeline pressure continues to be evident in PPI, and CPIX is expected to remain above 6% for most of the next three quarters. This, and the potential effect of higher inflation on inflation expectations, means it is likely that the SARB (also with an eye on its credibility) will raise rates again at the August MPC.

Needless to say, that on the back of these developments, the bond market failed to perform during the quarter. The All Bond Index (ALBI) produced a -1.65% return, while the Coronation Bond Fund posted a marginally better return of -1.52%.

It is noteworthy that while consumer demand data are generally still strong, there are clear signs of the peak having passed. Car sales are slumping, while other spending and consumer credit are starting to slow, hit by a perfect storm of higher rates, higher prices and (in June) the introduction of the National Credit Act.

A consumer slowdown will help ease concerns both over the current account deficit and inflation further down the line, while the latter will also be helped by the recently stronger rand. Thus, if the SARB does raise rates in August, there is a good chance that would be the end of the cycle.

The shape of the yield curve continued adjusting during the quarter, extending the level of inversion as upward pressure on short rates remained. Overweight the back end of the yield curve with a neutral modified duration position relative to the ALBI remains our preferred portfolio positioning stance.

Mark le Roux
Portfolio Manager

Despite losing ground in March, the All-Bond Index (ALBI) managed to return 1.6% over the first quarter of 2007. This was ahead of the 1.0% returned by inflationlinked bonds, but fell short of the 2.3% return generated by cash. Longer dated bond performance lagged over the quarter while the 1-3 year area produced a return close to cash. The Coronation Bond Fund returned 1.63% over the quarter.

Although the front end of the yield curve rallied somewhat over the quarter as the SARB left rates unchanged at the February MPC meeting, the longer end of the market weakened, resulting in a bear flattening of the yield curve. Earlier in the year prospects for inflation had looked better, resulting in the MPC's decision to leave rates unchanged. Since then, a number of factors took a turn for the worse, including a weaker rand and significantly higher oil and food prices.

We are now less optimistic about the inflation profile over the next year than we were previously. This is partly due to lingering concerns about the rand from the continued wide current account deficit, and is exacerbated by strength in oil and food prices. While we still think that any breach of the target that may occur would be small and temporary, we now see targeted CPIX inflation moving largely sideways over the next year, mainly between 5.5% and 6% - i.e. close to the upper end of the 3-6% target range. With a profile like this, we would not expect there to be much chance of SARB interest rate cuts over the next 12 months, especially if the current account deficit remains wide. We now think the first window for a rate cut (unless there is a sharp reversal in any of the risk factors such as oil and food prices) is June 2008.

Despite the worse (but not terrible) inflation profile, there are factors that are still supporting the bond market. An important structural one is the improvement in SA's fiscal position. In February the Minister of Finance announced that SA recorded its first-ever budget surplus in 2007/08 - and this figure was quickly revised upwards to 0.6% of GDP once the final fiscal year cash flows were announced at the end of March. The next few years are expected to show either small surpluses or deficits - to all intents and purposes, we are looking at a balanced budget over the next few years. One of the principal beneficiaries of this will be the bond market, where there will be a net buyback of debt this year. The supply side is thus looking very positive for bonds. While we anticipate that there will continue to be a significant amount of nongovernment issuance into the market (both corporate and parastatal), we would expect this to be more reflected in spreads of these instruments than in the actual underlying level of the yield curve.

The other current positive in the market is the one that concerns us in terms of sustainability: the positive global backdrop. Global risk appetite remains strong and an important support for risky assets, including emerging market bonds, but we remain concerned at anecdotal evidence of investors looking for yield without being fully cognisant of the risks involved. The biggest threat currently is probably a combination of lower growth in the US but coupled with higher inflation, leading to the Federal Reserve not being able to cut rates as quickly as some hope. Combined with lower US growth which would reduce demand for emerging market exports, this could be a catalyst for an unwind of risk appetite. We note that the Fed still expresses concerns about inflation risk being to the upside.

For SA, the most important consequence of a substantial reduction in risk appetite would be that funding the large current account deficit would become more difficult, and this would put the rand - and hence inflation - under renewed pressure. While timing remains unknown, we feel this is a risk we cannot ignore.

With our proprietary valuation models showing that valuations are stretched, the global and local (inflation) risks mentioned above and the competitive returns currently offered in the money market, we are cautious on bonds at present. We would emphasise, however, that these are cyclical factors and that the longer term positive structural story remains intact. The positive supply/demand story as well as the credibility of the SARB with respect to the inflation target should keep longer-dated yields supported, while short-dated yields will be more dependent on expectations of and actual moves in the repo rate.

Mark le Roux
Portfolio Manager

Bonds extended their gains into the fourth quarter, with the All- Bond Index (ALBI) up 5.6% for the quarter, to close the year at 5.5%. The Coronation Bond Fund produced a healthy 6.8% return for the year, comfortably outperforming the ALBI. 2006 was a year in which it was not just a matter of getting the duration of the portfolio correct, but crucial to have the fund positioned in the right area of the yield curve - the 12+ area produced a 10% return for the quarter while the 1-3year area returned a mere 2.3%.

2006 saw the end of the easing repo rate cycle and a 2% rise in short rates. Thus the two big questions going forward are whether we will see further increases in interest rates; and how the positive longer term structural argument for bonds will play off against the current challenging cyclical environment.

But before answering these, let's have a brief recap of 2006. Bond yields started in a bullish frame of mind at around 7.50% and very quickly firmed close to 7.00% by mid-February. However, a vicious sell-off in the rand, starting in May on current account deficit fears, saw bonds follow suit as inflation fears surfaced. The 10-year bond sold-off all the way to around 9.00% by September. However, the announcement of the very positive medium-term budget in October, coupled with a stronger US treasury market, saw local bonds rally back to 8.00% by year-end. In a highly volatile year, the All Bond Index produced a return of 5.5%, and the yield curve changed shape rather dramatically to a substantially inverted curve.

On the outlook for interest rates, consumer demand and the current account deficit appear to be the two main factors of concern for the SARB at the moment (as these are seen to pose risks to the inflation outlook).

While consumer demand has so far appeared to show little response to the interest rate rises, we believe that this is largely due to the lag effects and that there are indeed early tentative signs of a slowdown. The combination of rising interest rates and still-increasing consumer debt means that for the first time in this cycle of sharply rising debt, the debt servicing level (interest repayments) have exceeded the levels seen at the top of the 2002 rate hike cycle. While servicing levels are still far below the "crisis" level of 1998 and well below the levels seen throughout most of the 1990s, we do believe they are now high enough for consumers to start "feeling the pinch". This will help slow consumer spending to levels more consistent with the inflation target.

Recent data have seen the SARB revise the current account deficit for the first three quarters of 2006 smaller, recording levels of 6.1%, 5.7% and 5.2% of GDP respectively. While the deficit remains wide, we note that it has narrowed by almost 1% of GDP over this time - a time when the rand was still relatively strong for the first part of the year and when there was yet little impact from the interest rate rises. The expected slowing in consumer demand should be underpinned by the rand's depreciation this year (the currency is still quite weak despite the recent pullback, especially on a trade-weighted basis). This means that the rand is at far more competitive levels than it has been for some time, which should help both subdue imports and promote exports - a combination that should contribute to further narrowing the current account deficit.

One key risk for the current account remains the oil price. Oil is a significant import, and the deterioration in the deficit over the past couple of years is partly due to rising oil prices. So, despite our expectation that consumer demand will slow and the rand will help the deficit, oil does remain a threat.

Of course, what ultimately matters for interest rates is the effect of these factors on inflation. We think inflation may breach the upper end of the target range of 3% - 6%, but only by a small margin and for a short period of time. Thus we don't expect the breach to have a significant bearing on the SARB's actions, and believe that December may have been the last hike in this cycle. However, the risks remain tilted to the upside; any really nasty inflation surprises (possibly due to food or oil prices surprising on the upside), or a lack of meaningful improvement in the consumer spending data, could see the SARB raise rates again in February. Should this happen, we would certainly expect it to be the last rise in the cycle.

Regarding the question on the structural versus cyclical argument for bonds, the medium-term budget indicated that South Africa would, for the first time, move from a fiscal deficit to a fiscal surplus in the 2007/08 fiscal year. This will result in substantially less government bonds being issued in the bond market, with the result that (taking maturing bonds into account) there will be a net buy-back of government debt in 2007.

From an asset allocation perspective local fund managers appear short of bonds in their balanced portfolios, preferring to hold higher yielding money market instruments. Also, bond portfolios will drift shorter from a duration perspective relative to the benchmark as the All Bond Index is reweighted longer in February 2007. All of these factors further underpin the structural shortage of SA government bonds, and this is before the seemingly increasing voracious appetite of foreign investors is taken into consideration. Thus, we expect the demand/supply balance to be a strong support for bonds.

The rising short rates cyclical argument and the structural shortage of bonds is best illustrated by the massive inversion of the yield curve, where one year assets are trading at around 9.70% and 20 year assets at around 7.50%. Our interpretation of this is that the bond market is 'buying' the big picture long term structural story for SA bonds (low inflation after the cyclical blip and lower supply). This is keeping longer-dated yields anchored at lower levels, while short-dated yields are dependent on the repo rate.

Finally, we should not ignore the positive global story, which indeed is also a factor underpinning the better structural story in South Africa. We would note that US 10-year bonds seem unable to sustain moves much above the 4.5% level (which we would consider long-term fair value), and emerging market debt has defied all predictions and (after a blip in May) has continued to show very tight spreads on a historical basis. These factors remain very supportive of SA bonds too, but we should recognise that there is a potential risk to the bond market should this sweet international spot turn sour.

Mark le Roux
Portfolio Manager