The SA bond market gained 0.93% in September, with the belly of the curve outperforming. Nevertheless, inflationlinked bonds (ILBs) posted the best fixed interest performance, gaining almost 2.7% on the month, while cash again lagged with 0.45%. Year-to-date, nominal bonds and ILBs both returned 13.1%, well ahead of the 4.26% returned by cash. SA was included in the Citigroup World Government Bond Index (WGBI) as at the close on 28 September, and predictably September saw large foreign buying of bonds, with a net R8.4 billion being purchased. This brings the yearto- date total to R76.5 billion, well ahead of any full-year total. Past experience with WGBI inclusion has shown that inflows tend to slow down after the inclusion date, and the potential combination of a slowdown in inflows and a large current account deficit means that we continue to consider the rand as being vulnerable. (Note the rand has remained on a generally weaker trend since July 2011, despite the strong bond inflows.) Part of the reason for this is undoubtedly the rapidly worsening trade account, where record year-to-date deficits have been recorded repeatedly since February. We expect a current account deficit close to, if not exceeding, 6% of GDP for this year. The July repo rate cut will tend to worsen the current account further by supporting import demand, while export demand is contingent on (weak) external demand. Exports will also be negatively affected by strike action. Naturally, global risk appetite will continue to be an important factor in portfolio inflows and therefore rand performance. August consumer price inflation (CPI) rose slightly to 5%, indicating that a trough was reached in July. We expect CPI to continue higher from here, partly due to food price pressures, rising towards year-end and into 2013, with another breach of the target expected in the second half of next year. This forecast is at odds with that provided by the SA Reserve Bank (SARB) in the last monetary policy committee statement, where they expect an average of 5.2% next year and 5% in 2014. Given the SARB's clear tilt towards worrying about domestic and global growth risks, we cannot discount another rate cut. Moody's was the first of the ratings agencies to act on its negative outlook, downgrading SA from A3 to Baa1 in late September (it is now on the same ratings level as Standard & Poor's and Fitch). All three agencies kept SA on negative outlook, and we expect further downgrades to come. It is likely that three important upcoming events - the Medium Term Budget Policy Statement (MTBPS) in late October, the ANC National Policy Conference in December and the Annual Budget in February 2013 - will be watched closely. We currently expect that we will see further downgrades anytime between late October and late February. Note that while downgrades from the current ratings level still leaves SA relatively comfortably within the investment grade category, two notches down from the current level will mean that SA is on the lowest rung of investment grade. SA currently has one of the widest budget deficits within emerging markets, and needs to do more in reining this in to contain ratings deterioration. Local bonds also received some support from global factors during September as the Fed initiated another round of quantitative easing. This supported the US bond market, as well as sparking some more 'risk on' flows into emerging markets. Despite the building of negative domestic macro factors, the bond market remains relatively well supported for the moment, on the basis of both foreign inflows and some probability attached to a further repo rate cut. However, we believe that the combination of the factors outlined above will be bearish for bonds longer term.
Portfolio manager
Mark le Roux

Nominal bonds had an excellent month and second quarter, significantly outperforming inflation-linked bonds (ILBs) and cash over both periods, and over the last 12 months. The All Bond Index (ALBI) returned an impressive 14.6% for the year to end June, strongly ahead of both inflation (5.7%) and cash (5.8%). ILBs also had a decent 12 months returning 12.3%. The benchmark nominal government bond, the R186 (2026), rallied with close to 50 basis points during the quarter. Global risk aversion and the deepening crisis in Euroland continued to take centre stage, both locally and globally. The flight to safety was reflected in record low yields reached in core markets such as the US and Germany, while spreads on riskier assets widened. Although core yields ended the quarter off their lows reached in early June, they still gained from already low levels. By contrast, yields in countries at the centre of the Euro crisis rose over the quarter. The Greek elections were a key feature during the three-month period, but attention started to shift to the larger economies of Italy and Spain. Bond yields rose in both these countries over the period, especially in Spain on growing concerns over its banking sector. By late June, there was open talk of a bailout. Globally, other risk assets also lost ground on a combination of growing Eurozone concerns, weakness in global growth indicators and some disappointment about the extent of stimulus provided by the major central banks. Included in this group was the rand, which depreciated from R/$7.66 at end- March to R/$8.14 by end-June. Despite the weaker rand, SA bonds gained over the quarter, largely taking lead from the downward trend in US bond yields. The yield curve steepened over the quarter as the short end of the curve followed the FRA market, which started to price in a 50% odd probability of a rate cut. This was in response to the change in stance by the Monetary Policy Committee (MPC) in their May statement from previously indicating that the next repo move would probably be upwards to now being ready to move 'in either direction' as circumstances warrant. The market has interpreted this (probably correctly) as meaning that the MPC is currently more concerned about the fallout from Europe than current SA inflation. An improved short-term inflation outlook also provided support to the bond market. CPI generally came in below expectations during the quarter, largely due to stronger food disinflation than anticipated, while the sharp drop of 19% in the price of oil (Brent crude) since the beginning of the quarter will exert significant nearterm downward pressure on CPI. While CPI will probably fall to around 5% in July as a result, the medium-term outlook is less comforting, as the effects of the weaker rand this year start feeding into the numbers. There is also some concern that global food prices may be bottoming. Although we now see CPI within the target range for the rest of this year, we expect - in the absence of further sharp declines in the price of oil - for it to turn higher and breach 6% again next year. Given the improved short-term inflation outlook and increased demand for South African bonds due to its expected inclusion in the Citi World Government Bond Index, we increased the duration of our fixed income portfolios during the quarter. This was achieved mainly by taking exposure to long dated corporate bonds, issued by the big four banks, where the excess spread is still very attractive in our view. We were able to achieve yields in excess of 10% on a couple of these purchases of R186 (2026) equivalent instruments.
Portfolio manager
Mark le Roux

The ALBI returned 2.4% for the quarter, most of which was made in January, while the fund returned 2.6%. Longer-dated bonds outperformed shorter-dated ones over the period, and the inflation-linked index outperformed vanilla bonds as CPI remained above the target range. Cash lagged bonds quite significantly, and has lagged even more when looking at a 12-month return. Inflation-linkers remain the bestperforming fixed interest class over all time periods within the past 12 months. Note that the real return on cash has barely been positive over the last year, and on a forward-looking basis, current cash rates out to one year are expected to show negative real returns.

Despite a plethora of global and local market news, bond yields were largely unchanged at the end of the quarter compared to end-2011, as the rally in January was largely reversed during February and March. A more convincing downward move was generally seen in inflation-linkers, particularly in the shorter-dated R189 where its real yield moved deeper into negative territory. It closed the quarter at -0.5% on a combination of higher inflation and potential buybacks of the bond ahead of its maturity in March 2013.

On the global side, concerns about the Euro area ebbed somewhat as a restructuring agreement was reached on Greek debt, resulting in a 'voluntary' haircut of 75%. However, and despite the markets clearly showing relief, Greece is still not out of the woods: investors whose bonds fall under international (rather than Greek) law have still not reached agreement, and the Greek government continues to extend the deadline for these. The new 10-year bonds are already trading over 20%, indicating continued scepticism, and a third bail-out package is already being talked about. Meanwhile, concerns about Portugal remain, worries over Spain are increasing, and Ireland is to hold a referendum on the fiscal treaty on 31 May. Thus, while concerns about Euroland have receded for now, the potential for further upset from this angle is clear.

There was some divergence in core global bond yields over the quarter. German bunds barely moved, with the 10-year yielding 1.82% at end-March from 1.83% at end-2011. However, US bonds sold off somewhat on the reduction in risk aversion combined with some stronger-than-expected economic data. The US 10-year finished March at 2.21% from 1.88% at the previous quarter-end. SA bonds broadly tracked trends in the US, albeit finishing the quarter on a slightly stronger note.

The annual budget speech in February surprised markets on the positive side, with the Minister reining in the deficit projections. It has since been announced that the expected deficit for the fiscal year just ended (2011/12) is 4.5%, slightly better than expected at the time of the budget. Despite the better-than-expected data, bonds could not sustain much of a rally post the budget. This is partly because funding still remains high, and partly because there is some scepticism over the extent to which public sector wage increases can be contained - this being an important contribution to the expected lower deficit numbers. Moreover, soon after the budget and despite the improved numbers, Standard & Poor's joined Moody's and Fitch in attaching a negative outlook to its credit rating on South Africa, citing structural problems and the potential for politics to pressure the budget sometime in the future.

On the monetary policy side, although there is clearly no desire to raise interest rates anytime soon, the SARB has started expressing concern about more broad-based inflation pressures (albeit still in the context of a relatively sanguine inflation outlook). We agree that there is already evidence of these in the data, but are concerned that they may have more of an effect than is currently factored in by most analysts. We continue to see inflation above target through the first half of next year. The rand could be a game-changer, but continued passthrough from oil and food price hikes as well as the increasing likelihood of further second-round effects from petrol prices (with the Gauteng pump price nudging R12/l) keeps us cautious. We continue to believe that with inflation above target and growth around 6%, a negative real repo rate is too accommodative and we expect interest rates to start being normalised later this year.

Portfolio manager
Mark le Roux

2011 in review
The bond market performed largely in line with its yield to maturity (YTM) for the year. The long dated benchmark government bond (R186 2026 maturity) started at a YTM of 8.30% and ended it at slightly weaker at 8.47%. The All Bond Index recorded 8.80% for the year. The star performance within the index was delivered by the shorter dated R203 (2017 maturity) generating a return of 10.80%, while the ultra long dated R209 (2036 maturity) delivered the worst performance, returning only 2.70%.

Inflation-linked bonds (ILBs) had a stellar year, with the index returning 13% for 2011. The 5-year government ILB produced the top return of 16.5% within the index. The very short dated inflation-linked bonds saw their real yields decline into negative territory (R189 2013 maturity declined to -0.15% real yield) as demand for inflation protection increased sharply in response to a combination of headline inflation breaching the upper end of the Reserve Bank's target range and short rates on money market instruments moving into negative real territory.

For the local fixed interest market, 2011 was characterised by rising inflation, a depreciating currency (the rand lost 22% against the US dollar), rocketing food prices and a materially increasing fiscal deficit; all of which should have been substantially negative for a bond market. However continued concerns over global growth, plunging global bond yields (US 10-year is now below 2%), worries over the fiscal situation in a number of European countries, the continued foreign bond investor appetite for yield along with record low domestic short rates resulted in a decent offset to the fundamental negative backdrop for bonds.

Themes and expectations for 2012
Inflation
We expect inflation to remain elevated and above the 6% upper end of the Reserve Bank's target range during the course of 2012. The main drivers of this would appear to be food prices and the depreciation in the currency experienced last year. The maize price again reached new highs in December, with the year on year rate of change of this very important soft commodity now running at 99% over 12 months.

Short rates
The next move in short rates, we believe, will be upwards. However, given the relatively dovish stance of the Monetary Policy Committee, this will most likely only take place in the second half of the year. With a repo rate at 5.50% and inflation (in our view) likely to average above 6%, negative real returns can be expected in money market assets.

Yield curve
Government needs to borrow in excess of R150 billion from the bond market to fund the budget deficit in the new fiscal year. This is a sizeable issuance for the market to absorb and is likely to place upward pressure on bond yields during the course of the year, especially at the back end of the curve where most of the issuance seems likely to take place. With the Reserve Bank trying to keep short rates unchanged for as long as possible, this may result in the yield curve continuing to steepen in the early part of the year. However as soon as the first rate hike is signalled and believed by the market, the yield curve should flatten quite quickly.

Looking forward
Global government bond yields at sub 2% are unsustainable. A selloff in global bonds would be a major risk to our bond market, particularly when combined with the large funding overhang that we face this year. In addition, any delay by the Reserve Bank to take action against the rising inflation trend could have major ramifications for the local bond market - the longer they wait the more entrenched higher inflation expectations become.

We continue to run a lower than benchmark duration position in the portfolio, coupled with a holding in inflation-linked bonds.

Portfolio manager
Mark le Roux