After moving sideways for more than nine months of the year to June 2010, the past 3 months have seen a very strong performance from the SA bond market predominantly driven by foreign inflows and declining inflation. Over the past 12 months the All Bond Index (ALBI) has generated a return in excess of 15%, with inflation-linked bonds producing 10% and cash just over 7%.

Aggressive foreign buying of SA bonds continued during the month of September bringing the year-to-date foreign investment into bonds to around R70 billion. This flow appears to be on the back of large scale investment into emerging market bond funds by offshore investors in search of yield. These funds in turn invest in the individual underlying emerging markets of which SA is one. A further by-product of this foreign investment flow has been for the rand to strengthen, which has had the resultant effect of subduing inflation to most recently recorded levels of 3.5% year-on-year in August. Because the fall in inflation over the past few months significantly exceeded expectations, the result has been a bull market in local bonds over the past three months.

The global search for yield has its roots in very low US bond yields, which have fallen further over the past few weeks on rising expectations of another round of quantitative easing. The positioning in the bond portfolios remains one of a small underweight duration position relative to the ALBI, combined with approximately a 10% holding in inflation-linked bonds. This view is predominately based on the fact that we are at or very near the bottom of the current inflation cycle and that inflation is likely to be closer to 5.5% one year out. Our preferred curve position is in the belly of the curve, namely the 7-year area where the portfolio is overweight at the expense of the back end. We continue to see value in good quality corporate bonds trading at what we believe to be very attractive spreads over government bonds.

Portfolio manager
Mark le Roux Client

The All Bond Index (ALBI) managed a 0.27% return in June, short of the cash return of 0.56% and lagging well behind inflation linkers which returned 1.3%. The short and middle maturity buckets of the curve performed relatively well, but longer-dated returns were weak and even negative at the very long end. For the quarter, the ALBI returned 1.1%. The 1 - 3 and 3 - 7 years buckets again performed best, with these sectors beating the cash return of 1.7%, but yet again inflation linkers were the star performer in the fixed interest universe with a return of 5.1% for the quarter.

The second quarter of 2010 was largely dominated by a combination of global fears about sovereign debt (especially in the European peripheral countries) and domestic news that showed a combination of economic recovery taking hold but CPI inflation continually coming in lower than forecasted.

Although the massive IMF/EU rescue package announced in May helped stem the spiral that had been seen in peripheral euro markets in general and Greece in particular, it is clear that these economies are by no means out of the woods. Bond yields remain at elevated levels historically, and periphery spreads versus German Bunds remain wide. Moreover, CDS spreads show that concerns about sovereign risk have spread wider than just the periphery - a logical outcome given that the fiscal picture among major economies looks fragile as well. While CDS spreads in the core remain well below Greece (at 910bp) for example, and still show low risk of default, they have widened across the board since late last year, as shown in the table below. Perhaps the most worrying move here is France, where spreads have widened from 23bp in October 2009 to 93bp currently.

By contrast, spreads on emerging market debt - although off their lows of earlier this year - are not much different than they were in October 2009, and better than they were earlier in 2009. This contrast likely reflects two factors: one is that many emerging markets are currently in a healthier fiscal position than their developed market counterparts. The second is that capital inflows into emerging markets have been strong, partly justified by fiscal and growth fundamentals but also aided by very low G10 interest rates and another search for yield. As can be seen from the chart below, while the local bond R157 underperformed Emerging Market Bonds Index performance for a while last year, it has again been following its emerging market counterparts more closely recently. While local bonds too are off their best levels of earlier this year, they remain at better levels than they were for much of the preceding year.

Support for local bonds has come from a number of sources. As with other emerging markets, SA has also seen inflows. Foreigners bought a net R33 billion worth of local bonds in the first six months of 2010, of which R18.8 billion came in in the second quarter and R6.4 billion in June alone. These net purchases compare very favourably historically (the picture looks much the same in US dollar terms too). This has clearly been a source of support for local bond yields, helping offset the increased supply associated with SA's currently large budget deficit.

Local news has generally been positive for bonds. The 'Goldilocks' outlook that we alluded to some time ago has materialised, with CPI inflation surprising most initial 2010 forecasts on the downside while growth has exceeded initial expectations. In May CPI printed at 4.6%, comfortably in the middle of the target range. GDP grew by 4.6% in the first quarter of 2010, with export sectors as well as domestic consumption showing a rebound. This in turn has been positive for fiscus, and the indications so far this year are that the Budget deficit will come in significantly below the initial Treasury estimate of 6.2% of GDP. This in turn should help relieve funding pressure.

However, looking ahead, the outlook is not so rosy. Firstly, while funding pressure may be less than initially presumed, weekly bond supply remains high and cumulatively will be negative for the market. While CPI is still expected to fall slightly from its current levels, we think the bottom is near. One of the main drivers of lower inflation had been the stronger rand, but simply base effects mean that the rand influence will start waning within the next few months even if the rand moves largely sideways from here - and clearly there would be worse news ahead were the rand to weaken significantly. Leading indicators of inflation, including PPI, also support the view that CPI will have troughed by the early part of the fourth quarter this year. With a potential rise in CPI (especially if the rand weakens) combined with stronger domestic demand and already very low real interest rates, we think it is unlikely that further interest rate cuts are on the table. Rather, the next move is deciding when factors will combine in such as way as to induce the SA Reserve Bank to start hiking rates (although such a move is probably a year away yet).

We are also concerned about the potential impact on domestic bonds from global bond developments. While emerging market bonds have generally performed well this year, this is in no small part due to low interest rates and abundant liquidity flowing from developed markets - a situation that will turn at some point, and we would expect the strong flows into SA to reverse at the same time they do internationally. This will be especially concerning if domestic funding is still large. Withdrawal of stimulus in the US in particular is also likely to see US and global bond yields rise, and it is unlikely that SA bonds will be immune. While none of this is likely to be near term, these are some clearly significant risks for the market that cannot be ignored.

Our positioning in the fund remains largely neutral from a duration perspective, as we still consider risks balanced between a positive shortterm inflation outlook on the one hand, and supply issues and global risk aversion on the other.

Portfolio manager
Mark le Roux

The All Bond Index (ALBI) returned 2.1% in March, with gains driven by the longer end. The return for the quarter was 4.4%. These returns outstripped those of cash and inflation-linked bonds, both in March and for the quarter as a whole.

Bond yields have been in a general downward trend since mid-January, a trend that was maintained in March and which gained momentum following the SARB's decision to cut the repo rate by 50 basis points (to 6.5%) at the MPC meeting on 25 March. The SARB's move, which had not been fully discounted in the markets, was enabled by a combination of lower-than-expected inflation, and generally still soft economic data as well as continued rand strength which bode well for further disinflation. At this stage, we believe that most of the expected good news is factored in and our base case would be for rates to remain on hold for the remainder of this year.

Inflation re-entered the 3% - 6% target range in February at 5.7% (data released in March), which was sooner than many had expected. We think that underlying trends in consumer inflation look positive at the moment; there seems to be an absence of any significant demand-side pressure, while a broad number of categories continue to show beneficial influences from the currency. Indeed, most of the randsensitive categories are either within or below the inflation target range. The main factors holding inflation up continue to be administered prices, and even these appear to be less of a problem than had initially been expected (e.g. the Eskom price increase being approved at a lower level than requested). We think CPI could fall to around the mid-point of the target range during the course of this year. Movements in the rand will continue to be crucial and a reversal of rand strength remains a key risk.

Although growth has undoubtedly bottomed and is moving noticeably higher, this so far seems to be led principally by manufacturing (linked to exports and the global recovery) and domestic car sales (coming off an exceptionally battered base). In general, domestic growth indicators remain soft - for example, credit extension is still negative year on year. We do expect that growth will spread more widely over the remainder of the year, due to a combination of jobs recovery in manufacturing and the effects of low interest rates (and the strong rand) in general on domestic demand. While this will be positive - especially for tax revenues - it also brings a concern that, at some stage, the current account deficit will widen out again and start to be a negative for the currency (and in turn for inflation).

On 1 April, National Treasury announced preliminary revenue and expenditure data for the fiscal year ended March 2010, which showed revenue collections had picked up significantly towards the end of the fiscal year. Thus, just six weeks after the Budget Speech, Treasury has been able to revise the 2009/10 Budget deficit down by 0.5% of GDP to 6.8% of GDP. While no revisions have been made for the 2010/11 fiscal year, we feel it is quite likely that the number will be revised down from what we consider a conservative estimate of 6.2% of GDP. Even with these numbers, though, it should be noted that supply into the domestic bond market will remain at multi-year highs (especially if one takes parastatals into account).

The generally positive domestic news was underpinned by a move lower in emerging market spreads over March. However, another latent risk for both SA and emerging market bond yields in general arises from the US bond market, where yields have recently moved higher on a combination of stronger growth data and large supply, even despite expectations of interest rate rises being pushed out as core inflation surprises on the downside. As quantitative easing programmes start being wound down, we expect that supply issues will continue to dominate US and other developed bond markets.At some stage, though now it is looking more likely to be in 2011, major central banks will have to start reversing emergency low levels of interest rates as well. It is thus difficult to see an outcome where global bond yields do not continue rising into 2011, and this will almost certainly have an impact on SA yields.

We thus remain in a position of largely balanced risks, where shorter-term domestic outcomes have been positive for bonds (and may be so for some months yet), but where there are concerns about the longer term. As a result the fund has tended to remain largely neutrally positioned in terms of duration. Overseas investors seeking higher global yields have been more active during 2010 helping fuel the rally both in medium-dated bonds but also in the rand.

The fund reduced its exposure to long-dated maturities following the budget announcement of two new longer-dated issues and increased its holding of inflation-linked bonds to 8% as real yields weighed down by supply increased to attractive levels. Corporate bonds spreads also began to tighten as new deals were increasingly well supported.

Portfolio manager
Mark le Roux

Bonds had a decent month in December, producing a return of 1.2% - double that of cash (0.60%). For the year, though, it was a very disappointing one for the All Bond Index (ALBI) which returned -1%, underperforming cash by close to 10%. Inflation-linked bonds posted a below cash return for the month as the combination of improved perceptions of the inflation outlook as well as continued significant supply of inflation-linkers weighed on the asset class.

The weekly supply of new government debt remains to be the proverbial 'elephant in the room' that is putting pressure on the bond market. National Treasury had stepped up its nominal bond funding requirement to R2.1 billion a week in November, as well as issuing R600 million face value of inflation linkers (about double that in actual cash outlays required). Added to that is the continued state-owned enterprises (SOE) issuance.

Balanced against the negative story from the supply side is a continuation of the improving trend in the inflation outlook. CPI ended the year with a November release of 5.8%, the second month of it being within target range (3% - 6%). The continued rand strength coupled with weak money supply and negative private sector credit extension bodes well for the inflation outlook for 2010.

Risks to our relatively benign inflation outlook in 2010 come from a potential unwinding of the base effects of the lower food and fuel prices experienced in 2009, uncertainty over electricity price increases and the chance of a severe bout of global risk aversion which could result in a sharp retracement in the rand.

Looking forward, with supply weighing on and inflation supporting bonds at these yields, we are advocating a neutral duration position relative to the ALBI.

Portfolio manager
Mark le Roux