After a dismal first half of the year, in which the ALBI lost 6.7% since the end of 2007, bonds turned sharply in the third quarter. The ALBI racked up a positive performance in each month - including its 3rd-highest ever monthly return in July. The total return for the quarter was a hefty 12.6%. The OTHI sector, largely parastatals, was the star, returning some 15.3% over the quarter. Longer-dated bonds outperformed shorter-dated ones by a large margin as well, with the longest maturity bucket returning almost 20% for the quarter. Other fixed interest asset classes lagged dismally, with cash returning 3.1% and inflationlinked bonds showing a down quarter (-1.4%).

It can be seen from the chart below that bond yields had steadily risen from late last year till their peak around the end of the second quarter. This rise in bond yields had been largely driven by upside surprises in inflation (with both a weaker currency and sharply higher oil prices as major factors) and thus to the SARB's repo rate as well. In one sense, with bond yields having been driven well into double digits and undeniably cheap territory, they were ripe for retracement. On the other hand, the past quarter was a strange time to see that happen - given the background of financial market meltdown and risky assets losing favour, as evidenced especially in sharp weakness in both EMBI spreads and the rand.

Still, local markets took some succour from a spillover of the flight to quality (given poor equity performance and exchange controls), as well as what seemed to be a peak in the local short rate cycle following the release of the new CPI weights for next year and expectations of a sharp fall in inflation rates to come through in the first quarter of 2009. At the end of the second quarter there were still people looking for another 100bp or more rise in the repo rate; those forecasts were quickly scaled back and many analysts brought the timing of expected rate cuts sooner. Similar sentiments were expressed via the FRA market. More recently talk of aggressive rate cuts in SA has emerged; but we feel that in SA inflation is still too high and growth not nearly slow enough to justify a rate cut with CPIX almost double the upper end of the target range.

The strong performance of the OTHI subsector during the quarter was largely led by Eskom bonds. Following a credit rating downgrade by Moody's, the government made it clear that it would guarantee Eskom debt if requested, and Eskom later confirmed it was applying for such. As a result, spreads on Eskom debt narrowed dramatically (see chart below). While Eskom is a special case, appetite for non-government debt in general seemed to show some improvement over the quarter. The quarter's bond performance bears similarities to September 2001, when bonds strengthened despite a weakening rand - seemingly the only refuge for exchange control-constrained fund managers against a background of sharp equity weakness. Of course, a few months after 9/11 we saw a very sharp and nasty retracement in bond yields, but that did follow further sharp rand weakening and a change in expectations about SARB rates from further cuts, to hikes. None of these factors are what we currently expect - though it is as well to point out that we would have said exactly the same thing in September 2001, with the damage to the currency and effects of that really only becoming clear in late November/early December of that year.

There is perhaps a mitigating factor this time round - and that is that even with the sharp fall in the rand that we have seen over the past few weeks, the fall in commodities has offset that. For example, even after the petrol price reduction in October, there is still an over-recovery currently recorded. The inflationary implications of the rand's fall this time are being offset (so far anyway) by declines in commodity prices (including food prices). At the moment we still expect to see interest rate cuts from the second quarter of next year. However, the fact that bonds have run so far despite the increase in risk does make us cautious on the near-term outlook.

Thus, while we have been saying for some time that bonds offer value on a long-term basis, the sharp moves in the past quarter have in our opinion more than priced that in now, especially as we do not feel the market is adequately pricing in the short term risks. Indeed, on shorter-term measures bonds are now looking overvalued, and we still do not have much clarity as to whether some of these 'shorter-term' factors (such as the current increase in risk spreads) will in fact become more medium term ones. The Coronation Bond fund is thus currently positioned somewhat short vs. ALBI.

Mark le Roux
Portfolio Manager

The first half of 2008 has been one of the worst experienced in recent times for the bond market. The All Bond Index has returned -6.7% for the six months, making it one of the poorest periods to be in the bond market in the past decade. Long bond yields have risen more than 220 basis points to around 10.70%, a level last seen in 2002.

The massive problem which has impacted negatively on bond yields, and the majority of financial assets, has been the 'rampant' oil price which has fuelled inflation far beyond initial expectations. This is a phenomenon that is occurring both locally and internationally.

On a year-on-year basis oil is up by more than 100% in rand terms. The direct impact on inflation from this source has been enormous - one just has to look at the petrol price - but the indirect impact has also played a material role in the upward trajectory of inflation. Looking at the price of maize one realises that two of the major inputs into producing the maize crop are diesel and fertiliser - both oil by-products. Add to this the-well publicised Eskom tariff hikes and one quickly sees how the bond market has had to face an almost perfect storm.

The Monetary Policy Committee has responded to the rising threat of inflation by hiking rates at both the April and June meetings (10 rate hikes in the current cycle) as well as engaging in some very hawkish and vociferous 'central bank speak'. Judging by their actions and commentary, the SA Reserve Bank certainly appears committed to getting inflation back into the target range.

From a valuation perspective, good value appears to be returning to the bond market and when the interest rate cycle starts to turn, one can expect a strong performance from this asset class. The question does however remain as to 'when?', but hopefully a stabilising/falling oil price will provide that answer.

We have moved the bond portfolio from a short to a neutral position relative to the All Bond Index benchmark at this point in the cycle.

Mark le Roux
Portfolio Manager

The SA bond market had a particularly poor start to the year. The ALBI returned -1.88% for the quarter and -0.53% for the month of March. The long end of the curve was the hardest hit with the 12+ area losing in excess of 6.5% for the quarter, and the 1 to 3 year bracket fared the best, producing 1.6%. This weak performance from the bond asset class should be seen in the light of further negative surprises on CPIX inflation, a sharply weaker currency, an intensification of the credit crunch overseas (with the Bear Stearns debacle) and a widening in emerging market spreads. Needless to say, in this environment the all bond index once again underperformed both cash and inflation-linked bonds during the quarter.

Our analysis shows that we are currently very close to the peak in inflation. It is important to remember that inflation is a means of measuring the rate of growth of prices, which means that prices remaining high do not mean high inflation. Food prices, although not falling yet, are in the process of topping out supported by the huge supply response domestically. Oil remains an enigma and is likely to remain at speculative levels as long as geopolitical tensions persist in the Middle East. However, the one wildcard has to be electricity - to go from a 14% increase to a requested 60% in the space of a few months begs many questions? If the regulator grants such an increase, we could see the inflation rate peaking in double digits of around 10.50% by July of this year.

Evidence in the economy suggests that the past eight interest rate hikes, taking us from 7.00% in June 2006 to 11.00%, are in the process of working. Retail sales and vehicle sales are already under enormous pressure, with more to come as the lagged effect of monetary policy (12 - 18 months) works its way into the system. While the full effects of the four interest rate hikes in 2007 have not yet fully filtered through, any excess consumer demand in the economy has shown signs of abating. 'Yes' we have an inflation target, and 'yes' we are in breach due to factors beyond our control, namely oil and food. But would a further interest rate hike help? Or would the impact on the consumer be the equivalent of 'pushing on a piece of string?'

The turmoil in global credit markets has put the local corporate credit and securitization markets under severe strain. This, coupled with incessant funding pressure from the banks, has resulted in these markets virtually ceasing to function. Examples are the recent shelving of a home loan securitisation by one of the big four banks through lack of demand; The Development Bank of Southern Africa issuing only R1billion of a proposed new R2 billion bond due to lack of bids, and most recently, the large blue chip, Anglo American being forced to withdraw their inaugural bond issue due to insufficient demand at a reasonable price (140 bps over the referenced Government bond).

Maximum exposure to corporate credit by institutional investors and a lack of liquidity in the majority of credit issues has all but caused trade in this market to dry up. Furthermore, one of the largest money market unit trust funds in the country which had been an aggressive accumulator of bank conduit paper (a regulatory arbitrage vehicle that invest predominantly in securitisations and corporate credit) has virtually withdrawn from this area of the market, leaving it and the credit market in an oversupplied position.

A further problem in the credit market has been the lack of realistic price discovery and unrealistic mark to mark of a number of the assets due to poor tradability and lack of liquidity. A deteriorating economic outlook and rising interest rates have also put pressure on a number of the underlying assets in the securitisation vehicles.

This rather toxic concoction will need to right itself before vast sums of planned new issuance can find its way into the bond market. That said, we believe that the time to pick up bargains in this area of the market could be now.

We should be approaching the cyclical peak in inflation and from a fair valuation point of view bonds are beginning to show value. Thus we believe now is the time to start to add duration to the fixed income portfolio.

Mark le Roux
Portfolio Manager

The SA bond market returned 0.9% for the quarter. This lacklustre performance should be seen in the light of more negative surprises on CPIX inflation; two interest rate hikes, an intensification of the credit crunch overseas, and a widening in emerging market spreads. Against that backdrop, the fact that bonds managed a positive return is actually not bad at all! The only really supportive factor was a decline in US bond yields, though that was largely a combination of flight-to-quality bids and fears about US growth, neither of which is particularly healthy for SA. The rand moved largely sideways over the quarter, with a brief spurt of strength in late October/early November proving unsustainable. The all-bond index underperformed both cash and inflation-linked bonds for the quarter and the year.

Each of the three CPIX inflation releases during the final quarter of the year surprised market forecasts on the upside, and the end result was that CPIX had moved up sharply from 6.3% in August to 7.9% in November. This is well above the upper limit of the SA Reserve Bank's (SARB) 3% - 6% target range. The December figure, to be released at the end of January, will almost certainly be well north of 8%. The fact that the driving factors behind the inflation rise remained food and energy added to the SARB's concerns about second-round effects, and the data most probably sealed the decision to raise the repo rate 50 basis points at each of the October and December MPC meetings. The repo rate has now increased by a total of 400 basis points in this cycle.

However, the news was not all bad from an inflation perspective, and indeed from a forward-looking standpoint there are clear signs of improvement. The rand has generally remained stable (not just over the quarter but throughout 2007) and the lagged effect of this will help dampen CPIX beyond the first quarter of 2008. Indeed, the stable rand has already had something of a positive impact on PPI, and unlike CPIX that has tended to surprise on the downside. PPI is a leading indicator of CPIX trends. Meanwhile, the SARB's other stated concern - consumer spending - has shown signs of a sharp slowdown in recent data, and it can only be a matter of time before this is reflected to an acceptable extent in the credit data.

The SARB continues to find itself in a tight spot, with no sign of pressure easing on food and fuel prices, yet all indications are that more than enough pressure has been brought to bear on consumers. There must be a limit to the extent to which exogenous factors (and here we would include Eskom tariff increases) can drive monetary policy in the face of slumping consumer spending. It may be an opportune time to stick our necks out and say that it is likely time that the SARB will pause at the January MPC to see the effects of previous rate hikes - particularly if it is forward-looking.

The international backdrop will continue to be crucial. There are heightened concerns about growth in certain developed markets, particularly in the US. This could keep US bond yields low. However, if the credit crunch continues, risk aversion may stay relatively high and risky assets may stay under pressure. Capital flows into SA have been a key factor supporting the rand in the face of the wide current account deficit, and the rand could become vulnerable if sentiment towards emerging markets in general turns negative. This will remain a key risk this year. A positive side effect may be that concerns about growth should help alleviate some of the pressure recently seen on oil prices.

From a domestic perspective, the outlook is cloudier in the shorter term than the medium term. CPIX is expected to remain elevated in the first quarter, but should begin declining meaningfully from the second quarter and should slip back inside the target range by the third quarter. Coupled with what we expect to be continued evidence of a consumer slowdown, this should provide space for interest rate reductions in the second half of this year. This more positive outlook for bonds is again predicated on the assumption that any depreciation in the currency will be moderate, and is again held hostage to developments in oil and food prices. While the medium term outlook is basically positive, therefore, it remains fraught with risks and the SARB is likely to remain cautious. This fundamentally positive outlook tempered by a number of risks probably argues for keeping duration fairly close to the benchmark at present.

Mark le Roux
Portfolio Manager

The objective is to offer a combination of high income and capital growth for a maximum overall return by investing primarily in interest-bearing securities issued by the South African Government and certain parastatals. The fund will strive to consistently outperform the Bond Index.

This fund will invest in South African gilts, bonds, fixed deposit and other interest-bearing securities.