Bonds showed a marginally positive return in September, with the All Bond Index (ALBI) returning 0.08% and a respectable 3.0% for the quarter. Although the shorter maturity spectrum outperformed in September, it underperformed the rest of the index for the quarter, with long-dated bonds and especially non-government bonds being the best performers. The third quarter also saw bonds outperform both cash (1.9%) and inflation-linked bonds (1.4%). However, bonds still show a negative return year to date, lagging well behind both cash and inflation linkers.

The lacklustre performance of bonds in September was largely due to a weakening towards month-end, which seems to have been largely influenced by the retracement in FRAs at the time (see chart below). These moves followed the South African Reserve Bank's decision to leave interest rates on hold at the September MPC meeting (following a surprise cut in August). Although unchanged rates had been consensus, it was clear that the markets were getting bullish on a possible rate cut and thus disappointed at the actual outcome.

Against this background, the bond market largely ignored what should have been positive factors on other fronts: during September the rand strengthened further, US bond yields fell and the Emerging Markets Bond Index (EMBI) spread contracted. Economic data remained mixed from a bond market perspective. While economic activity data remained weak, there were some upside surprises; and conversely while inflation continued to fall, the rate of decline remains gradual and CPI is still above the target range. While the bond market does not seem to have taken much notice of the stronger rand we would emphasise that should the currency stay around these levels for any length of time, it has the potential to positively (and significantly) influence inflation going forward. We have already had a 5% petrol price cut announced for October and a number of other categories - including food prices - will be positively affected by rand appreciation. The risk is thus that inflation falls into target sooner than the market currently expects and that 2010 inflation is generally better than current market forecasts.

The biggest concern probably remains to be the huge amount of supply to come to the market. The budget deficit has widened sharply in the first five months of the fiscal year as revenues show the effects of recession and expenditure on investment projects is frontloaded in the fiscal year. While official numbers will be announced later this month in the Medium-Term Budget Policy Statement, it looks like the budget deficit for the current fiscal year will probably be well north of 7%. However, there was a tentative improvement in both revenue and expenditure in August after some terrible figures earlier in the fiscal year and the final outcome may well be better than what is implied by simply extrapolating the year-to-date numbers. Even so, the final number will still be large. The chart below shows how weekly bond market funding has increased of late. Unless the fiscus manages to correct, or unless there is another offshore issue, bond market funding will need to rise even further. Despite the corporate issuers (mainly banks), the funding requirement from Government and state-owned enterprises (SOE) remain huge.

The modified duration of the ALBI continues to move longer with every re-weighting and is now at 6.12. The reason for this is that the bulk of the heavy issuance, with respect to both Government and SOE debt, is taking place at the longer end of the curve. With issuance expected to remain high and with the bulk to continue taking place at the longer end, the ALBI MD should continue to move longer for a while. This will provide some support for bonds from benchmark tracking funds.

Portfolio manager
Mark le Roux

The All Bond Index (ALBI) gave up some ground in June, resulting in an anaemic return of 0.3% for the quarter. The shorter-dated area of the curve was the right area to be in, but that still underperformed cash (both in June and for the quarter as a whole). While inflation-linked bonds performed well throughout the period, they lagged cash in June. Year to date, inflation linkers have been the best performing asset class, followed by cash, with the ALBI lagging significantly behind.

A number of factors undermined local bond yields this year and especially in the second quarter when yields failed to take much heart from, for example, a stronger rand. Also note that the lacklustre performance of bonds has happened despite the aggressive easing in short rates this year - the South African Reserve Bank (SARB) took just 6 months to unwind almost all of the tightening put in place over the two years from June 2006 to June 2008.

Firstly, consumer price inflation (CPI) has surprised on the upside in each of the five releases for 2009. Even the fact that producer price inflation surprised on the downside did not do much to temper the caution signalled by the CPI outcomes. While we may yet see some more rapid downward movement in CPI owing to the recent stronger rand, many analysts have had to revise their forecasts higher, which has undermined bonds. However, this has presumably been one of the factors supporting inflation-linked bonds.

A second factor undermining local bonds this past quarter has been the rise in global bond yields. The US 10-year yield has risen from around 2.70% to 3.50%, threatening the 4% level at one point. As talk on the global stage has turned to recovery and with it exit strategies from the expansionary policies, including quantitative easing, global bond yields have risen. SA bonds often move in tandem with global bonds and this time has been no exception.

Thirdly, as fiscal positions almost everywhere have suffered from the economic slowdown (i.e. declining tax revenues as well as spending pressures), concerns have mounted about the large increases in the supply of bonds required to fund fiscal deficits. South Africa has been no exception to this, and just past quarter-end Finance Minister Pravin Gordhan announced some details of the revenue shortfall to date - significantly worse than many in the market had anticipated. From an originally budgeted deficit of 3.8% of GDP announced in February, it now looks likely that the deficit will probably come in in excess of 5% of GDP. Indeed, if trends do not improve from what we have seen so far in the fiscal year, it could even be in excess of 6%. While the exact intentions for funding this deficit remain unclear at present, what is clear is that the domestic bond market will not escape unscathed.

Finally, despite our earlier mention of the rapid unwind of last year's rate increases, note that the SARB paused its easing cycle in June against market expectations of a further 50bp repo rate cut. While this is positive for the bond market in the longer term (as it supports the longer-term inflation outlook), in the short term it acted to brake potential gains in domestic bonds.

The near-term outlook for bonds remains murky. On the one hand, a positive argument can be made from the likely trends in CPI and the fact that the market may well have underestimated the effect of a stronger rand on pulling inflation rates down from current levels. But on the other hand, concerns about supply pressure will remain and may well weigh the market down for a while, especially while the exact composition of the revised funding requirement remains unknown.

Portfolio manager
Mark le Roux

The bond market lost just over 5% in the first quarter of 2009. While losses where realised in January and February, the All Bond Index (ALBI) stabilised in March, however, against the backdrop of a significant difference in performance across maturity bands. For the quarter, short-dated bonds returned +2.3%, while the longest dated bonds (12 years and more) lost 10.8%. The short end was supported by a 200bp reduction in the repo rate since the start of the year as well as expectations of further aggressive easing. Meanwhile, the long end underperformed due to higher-than-expected inflation data and probably some concerns about the large amount of supply due to hit the market as well as a retracement in global bonds.

Global bonds have been a significant driver of local bond yields over the past few months as can be seen in the chart below. Both global and local bond yields bottomed at the end of last year as the risk aversion/safe haven bid and concerns about a deepening global recession drove bond yields down. The response of the G7 (and other) policymakers, throwing large amounts of both fiscal and monetary stimulus into the pot to mitigate the economic crisis, saw bond yields rising again into 2009 as optimism about an eventual recovery took hold and a rotation into some risky assets was seen (the MSCI Emerging Markets index returned in excess of 14% in March and 1% year-todate).

With regards to local fundamentals, there are conflicting influences on bonds. We are in a situation where the growth outlook has been continually downgraded and, while opinions vary on its extent, a recession has now become the consensus forecast. As an offset, however, the inflation outlook - which briefly looked very promising late last year - has taken a turn for the worse. Both January and February CPI numbers (released in February and March) surprised the market on the upside and the oil price appears to have arrested its decline.

Furthermore, funding pressures from the budget deficit, as well as funding for the parastatals' investment program, is set to add significantly to the supply of bonds. As the economy slows beyond original expectations, we have already seen the 2008/09 fiscal deficit revised wider to 1.2% of GDP (from a 1% of GDP estimate made just weeks earlier) and we are likely to see estimates for the 2009/10 deficit revised wider as well - probably in excess of 4% of GDP. While this is well below the kind of deficits being budgeted for among the G7, it will be the largest SA has seen since the 1996/97 fiscal. In addition, the total public sector borrowing requirement will be the biggest as a percentage of GDP since the 1980s.

Despite the gloomier inflation and supply pictures, markets remain focused on the poor growth outlook and on international precedent that has seen central banks slashing rates to support growth. There is also a continued expectation that the Reserve Bank, which has now cut interest rates by 250bp since December, will deliver further deep rate cuts. As a consequence, the yield curve has shown a sharp normalisation over the past few months as well. Market expectations of rate cuts have been scaled back somewhat on the worse-than-expected inflation data but are probably still too optimistic on the extent of the cutting cycle.

A major negative in March was that the corporate credit market has been performing very poorly over the past few months, with some significant spread widening seen in a number of the higher quality corporate credit bonds. In the eyes of the rating agencies the economic background has had a negative impact on cash flows and as a result they have downgraded a number of companies' credit ratings. This, coupled with a very illiquid market, resulted in a number of corporate bonds suffering significant mark-to-market knocks.

In the shorter term we believe that bonds may remain overvalued as the market continues to focus on slow growth and further repo rate reductions. In our view, the market is fundamentally expensive and the bond unit trust is now positioned underweight relative to the ALBI, while not being aggressively so as we realise that the growth background may support bonds in the shorter-medium term.

Another month, another bonds bull market.

The past 6 months on the bond market have been nothing short of amazing. The ALBI has returned just north of 25% over the past 6 months (and that is not an annualised number) and returned close to 7% for the month of December alone.

The interest rate cycle in South Africa has finally turned. On the 11th of December, Reserve Bank Governor Tito Mboweni armed with a knobkerrie and a MPC statement, delivered a cutting blow to interest rates by lowering the repo rate by 50 basis points to 11.50%. More importantly, it has signalled the start of what the market believes will be a fairly long and aggressive rate cutting cycle in the year ahead.

The primary driver behind the rate cut has come from the expected decline in inflation into 2009. This in turn continues to be driven by a rapidly falling oil price, combined with the reweighting and re-basing of the CPI (which takes place in January) coupled with a weak global economic outlook. The rand price of oil, again, declined sharply in December resulting in another large reduction in the petrol price (-136c/l) and diesel (-168c/l) announced in the first week of January.

Bonds were expected to firm in this environment but the extent of the rally way exceeded even the most ardent bond bulls. The benchmark R157 government bond fell by over 100 basis points in yield, from 8.34% to 7.21%, for the month of December. It even traded below 7% at one point during the month. Further yield curve normalisation also took place during the last quarter.

In December the fund had a decent month producing a return of 7.17%, while over the past 12 months generated a return of 17.13%, slightly ahead of the benchmark return of 16.97%.

Mark le Roux
Portfolio Manager