September proved to be a tough month for the local bond market, with foreign selling putting upward pressure on bond yields. During this period, the All Bond Index (ALBI) lost just over 2%, while inflation-linked bonds (ILBs) also came under pressure losing 1.2%. Cash outperformed during the month with a return of 0.47%. However, over the past 12 months bonds and cash performed in line with each other at 5.9%, while ILBs have been the star performer, producing a 9.2% return.

During the past quarter, foreign interest in buying South African bonds reached fever pitch towards the end of August. Foreigners piled en masse into high yielding SA local currency bonds, mainly on the back of declining yields on long dated bonds in the developed world.

As at the end of August, on a year-to-date basis, foreigners had bought close to R50 billion worth of our bonds. The "carry" pickup of between 5% and 6% was very attractive indeed, but as with anything in the market, it doesn't come for free. The risk that they seemed to miss was the expectation that the rand would remain stable (and overvalued) into perpetuity. At its worst point in September, the rand sold off 15%. This sell-off effectively wiped out the carry yield pickup foreign investors were looking to earn on SA bonds and a fair deal more. Basically all the SA bonds bought in rands by foreigners this year are now sitting at a book loss. Foreign investors have responded by selling R14 billion worth of SA bonds during the latter part of September.

The implications for inflation are worrying should the rand's weaker tone be sustained. We have already been of the view that a breach of the 3% - 6% target range is likely by the fourth quarter of this year. The recent rand weakness will have some shorter-term impact (almost immediately through petrol and with a slightly longer lag through food), but most of the currency move should be reflected in next year's inflation data. Should the rand's current levels be sustained, and in the absence of any significant downward move in global commodity prices, the risk of a later and higher peak in CPI is very real. Clearly, currency moves are highly volatile and uncertain, but if the current level of the rand is sustained our CPI forecast would move from peaking just over 6% and a return to target in the first half of 2012, to one where the peak may be around, or over, 7% with no return to inside the target range in 2012 at all.

Such an outlook is exacerbated by stubborn cost-push pressures. In particular, lead indicators for food price inflation - which had earlier begun to indicate a peak in food inflation were in sight - have started turning up again. Maize prices on the South Africa Futures Exchange (Safex) are around all-time highs and at the time of writing, are up a startling amount on a year-on-year (y/y) basis (the number that matters for inflation) - white maize is up almost 80% y/y and yellow maize over 60% y/y. These are important for local CPI, both directly in grains and indirectly via animal feed. Given the usual lag Safex prices have to food inflation, this implies we will see high food inflation into at least the early part of next year, with the recent rand moves potentially prolonging this.

On the fiscal front, the headwinds are also starting to gather momentum. Revenue collection appears to be lagging and the deficit is likely to be wider than budgeted. All eyes will be on the Medium Term Budget Policy Statement towards the end of October for an update on the country's latest fiscal situation. Implications for the bond market are that supply/issuance of government bonds could increase to cover this shortfall.

Outlook
In summary, we believe real returns from cash and bonds are likely to be relatively poor over the longer term in SA. Short rates are likely to remain lower for longer, while inflation is likely to become problematic and, in SA, remain above the upper level of the target range into next year. Running shorter duration positions relative to benchmarks, combined with a liberal inflationlinked bond holding appears to be the way forward. Portfolio manager Mark le Roux

I’ve got chills. They're multiplying. And I'm losing control - Danny Zuko, from the song ‘You’re the one that I want’ featured in the 1978 movie Grease.

The happenings in Greece have become the main driver of "risk on - risk off" investor behaviour throughout global financial markets. Will they default/restructure or won't they? If they do, will the contagion spread to those countries that are 'too big to fail and too big to bail' like Spain, for instance? While political leaders in the EU appear to have the will to bail Greece out, the Greek population seem vehemently opposed to the austerity measures that need to be introduced.

Under the now gloomy shadow of the Acropolis, the US 10- year bond yield rallied by around 50 basis points to below 3% during the quarter on some softer economic indicator data released in the US as well as safe haven demand as contagion from the Greek crisis continues to pose a threat to Euroland. Despite the fiscal woes of a number of European countries, the ECB has begun its rate hiking cycle. ECB chief Jean-Claude Trichet hiked short rates by 50 basis points in April and by another 25 basis points in July after signalling 'strong vigilance' with regards to inflationary pressures in the last week of June.

Local bonds have taken their cue from US Treasuries. During the quarter, we have seen the yield on the R186 government bond (maturing in 2026) rally by around 30 basis points to close to 8.50%. Foreign investors have once again returned to the SA bond market and were the main drivers behind the rally. For the month of June alone, foreign investors bought approximately R13 billion worth of SA government bonds. With the rand being relatively stable during the quarter at around R6.80 to the US dollar, and still no sign of rate hikes in the US on the horizon, the carry trade is still alive and well from the foreign side.

Local inflation data continued on its upward trend, passing the midpoint of the SARB's inflation target range in June at 4.6%. Food and energy prices remain the key drivers of inflation and our expectation is that CPI will approach the upper end of the target range of 6% in the fourth quarter of this year. So far, the MPC appears reluctant to act on this rising trend in inflation and the rhetoric coming from the members appears to be that they are waiting for secondround effects to manifest themselves in underlying inflation before responding. With the repo rate currently at 5.50% and inflation heading for 6%, negative real short rates towards the latter part of this year appear to be on the cards. Against this backdrop, we still regard inflation-linked bonds (ILBs) - yielding between 2.50% and 3% real - as attractive alternatives in the SA fixed income space. For the quarter, the All Bond Index produced a solid return of 3.9%, pretty much in line with ILBs (where one has seen some recent real yield compression) and well ahead of cash which only managed a 1.4% return. The fund was ahead of the benchmark for the period with a return of 4.01%.

On the domestic fiscal front, a substantial deficit still needs to be funded. Large weekly government auctions of R2.1 billion fixed-rate bonds and R600 million ILBs continue to take place and this is unlikely to change in the near future. Given the relatively large supply of bonds, coupled with rising inflation and our view that the next move in short rates is likely to be up, it is hard to envisage a further meaningful rally in long bond yields in the near future from current levels.

We continue to favour running shorter duration positions in our fixed interest portfolios and remain invested in ILBs.

Portfolio manager
Mark le Roux

The All Bond Index (ALBI) posted a positive return of 0.49% in March, marginally ahead of cash (0.47%) and a little behind Inflation Linked Bonds (ILB) which delivered a return of 0.58%. For the quarter, the ALBI was down by 1.6%, with the losses all coming in at the longer-dated area of the curve. By contrast, ILBs returned 1.2% and cash 1.4% for the period.

The first three months of the year was marked by a series of market-shaking events, encompassing natural disasters, political crises and continued economic concerns in some areas. While fears about the sovereign debt crisis in the European periphery was never far from the headlines, floods in Australia in January, political upheaval in the Middle East and the earthquake/tsunami that hit Japan in March all took headlines and rattled markets. From a bond market perspective, there tended to be conflicting effects from these events, as on the one hand bonds benefitted from a safe haven bid, but on the other hand the impact on already-tight food and oil markets saw inflation fears intensify.

SA bonds continued to follow the lead of US Treasuries. These benefitted from a safe haven bid as well as large purchases by the Bank of Japan as it intervened in foreign exchange markets to try and prevent the yen from strengthening following the earthquake. Treasuries (and SA bonds) had weakened significantly late last year, but the flight-to-safety bid appears to have put a lid on weakness for now and Treasuries essentially moved largely sideways over the first quarter. SA bonds were a bit late to 'catch up' to the weakness of US bonds in the fourth quarter of 2010. So despite the largely sideways move over the past month, they were weaker for the quarter as a whole.

As mentioned previously, we have continued to see inflation pressure arising globally from higher food and fuel prices. These pressures are beginning to feed into SA inflation in a more concrete way. There are also concerns about more generalised inflation pressure. Globally, these include the fact that price rises are occurring against a background of generally accommodative policy; Chinese wages appear to be rising and Chinese export prices with them; and there are concerns that supply chain disruptions from the Japanese earthquake/tsunami could see electronics and related prices come under pressure as well. In South Africa, although the rand has remained remarkably strong (largely thanks to a weak dollar), there are still signs of import price pressure starting to come through and we continue to be concerned about the second-round effects of food and fuel prices given relatively high wage increases and still very accommodative local monetary policy. We continue to think that inflation will reach or breach the upper end of the 3% - 6% inflation target range later this year.

On the fiscal front, there was good news at the margin of a somewhat better-than-expected revenue number for 2010/11, leading to a provisional downward adjustment in the Budget deficit to 5.0% of GDP (from an estimate of 5.3% at the time of the February Budget). However, this is still a large number and bond supply into the market will remain relatively high as well.

We thus remain concerned about bond yields from both inflation and supply factors. History has shown that supply tends to impact more as it happens than to be discounted in advance. These domestic concerns are further reinforced by an expectation that US bond yields will continue to rise over the course of the year as growth and inflation expectations continue to rise, concerns over the US fiscus grow and as the eventual end of quantitative easing and the zero interest rate policy draw nearer. Pressure on US bond yields will likely see global yields rising, including SA.

With all of that in mind, we retain an underweight relative to benchmark modified duration in the portfolio and continue to hold inflation-linked bonds.

Portfolio manager
Mark le Roux

Following a weak November, the All Bond Index (ALBI) gained 1.7% in December, which brings its return for the final quarter of 2010 to 0.7%. For the 12 months to December, bonds returned 15%. Although this performance was well ahead of other fixed interest instruments (with inflation linkers returning 11% and cash returning 6.9%) as well as preference shares returning 13.6%, bonds lagged equities with the JSE All Share Index returning 19% for the year.

The small gain posted by SA bonds in the fourth quarter was set against a mixed background of influences. On the positive side, the rand strengthened during the period and appetite for emerging market bonds in general remained healthy. This was evidenced by a lower EMBI spread. However, US bond yields rose during the period on improved optimism about a recovery in the US. The effect of local short rates was interesting: bonds held onto their third quarter gains early in the fourth quarter of 2010, partly on optimism about another rate cut. Although this optimism was rewarded with a 50bp cut to 5.5% by the SARB in late November, it did not support the bond market. In fact, bonds sold off in response to the rate cut - possibly signalling some investor concern about a potential upward move in inflation this year. This concern would have been underpinned by two consecutive worse-than-expected CPI inflation numbers (even if the absolute level is still low, at 3.6% in November). Breakeven inflation derived from the shorter end of the inflation-linked curve (2013 and 2017) remains near the top of the target range, at over 5.7%.

Foreigners also turned less positive on SA bonds during the period. While flows into emerging market bond funds slowed, in general they did not turn negative. However, this was not the case in South Africa, where foreigners sold a net R24 billion worth of bonds over the period. This came after very strong buying in the first three quarters of the year (which had been largely in line with general emerging market flows). For the year as a whole, foreigners purchased a net R44.5 billion worth of bonds - a record inflow for a single year.

Recent fiscal data remains a creeping concern. Earlier in the year we had thought that National Treasury's Budget numbers were too pessimistic - and indeed the Budget deficit was revised down in the Medium Term Budget Policy Statement. However, the past couple of months' data appear to have been weaker than might be expected (even taking seasonal factors into consideration). This has been a combination of weaker revenue performance and continued steady expenditure growth. At this stage we appear unlikely to outperform Government's revised target of a Budget deficit of 5.3% of GDP in FY10/11. If revenue does not start improving soon, the deficit may in fact slightly exceed this target.

A myriad of factors are likely to affect SA bonds this year and on balance we believe we are likely to see bond yields rising over the course of the year. The main factors are:

Ø US growth is expected to gain further traction and we expect US bond yields to rise over the year in response. Over the long term, this is an important driver of SA bond yields.
Ø While emerging market growth remains attractive, concerns are building about inflation in emerging markets and bond yields in these countries could therefore come under pressure too.
Ø More specifically, we also expect inflation in SA to rise towards the upper end of the target range as base effects reduce the positive currency impact and commodity price rises (particularly food and oil) outstrip the currency.
Ø Risk appetite remains uncertain, with the fiscal crisis in the euro peripheral countries far from resolved.
Ø While the rand has performed well and may continue to do so for a while, we believe the currency is overvalued. Further, improving SA growth and higher income payments to foreign holders of domestic securities are likely to see the current account deteriorate, which will put pressure on the currency should capital inflows lose momentum.
Ø We do not believe there is further scope for cutting interest rates. Should any further rate cuts indeed materialise, we would take that as another negative for the longer-term inflation outlook.

With all that in mind, we retain an underweight position relative to benchmark modified duration in the portfolios and retain a holding in inflation-linked bonds.

Portfolio manager
Mark le Roux