The third quarter of 2014 was a torrid time for the SA bond market, which was buffeted by crosswinds from global markets, the failure of African Bank as well as adverse movements in the local interest rate, currency and inflation. Despite these developments, bonds still managed to produce a positive return for the quarter, with some support from the stronger US bond market. The return of 2.2% on the All Bond index in Q3 outperformed cash (1.5% for the quarter) and inflation-linked bonds (1.0%).

The positive quarterly return notwithstanding, it should be emphasised that the bond market saw a rather abrupt turnaround in September itself. Yields fell about 40bps between end-June and early September, but then deteriorated sharply during the rest of the month. While US bonds bolstered the local market for much of the quarter, this support fell away at quarter-end as SA bonds succumbed to a significantly weaker currency. The rand was hit by general emerging market nervousness, and undermined further by local twin deficit data. Both the trade account and fiscal account for August showed significantly wider deficits than expected. Thus far bonds have been relatively resilient given the extent of the move in the currency. The twin deficits reveal both a lack of fiscal consolidation (especially when compared to our peer countries) and an inability of the trade account to benefit from a significantly weaker currency (probably due to strike action). The trade account and fiscal account data have disappointed expectations for most of this year, and played an important part in driving down the local currency. The rand weakness has also been blamed on general global conditions, which have resulted in a stronger dollar and weaker emerging market currencies. Partly due to these factors, foreigners were large net sellers of bonds (of almost R25bn) in the third quarter.

While the global background was somewhat fraught, domestic factors were also not very supportive of bonds. Inflation surprised on the upside and remained above the top of the 3-6% target range, with August CPI rising to 6.4%. There were two MPC meetings in the quarter: the SARB raised the repo rate by 25bps to 5.75% at the July meeting, but left rates unchanged at the September meeting as growth had once again deteriorated. The major news at the September meeting was the announcement by Gill Marcus, whose term as governor ends in November, that she would not be available for another term. (Deputy governor Lesetja Kganyago has since been appointed to replace Marcus.) Even amid indications of falling food and energy inflation, the rapid rand depreciation near quarter-end kept fears of inflationary pressures alive. Comments by SARB officials have made it clear that we remain in a hiking cycle - policy is still very accommodative and needs to normalise - and that disagreements are over the timing of, rather than the need for, further hikes. Aside from economic developments, the local markets were shaken by the failure of African Bank (Abil) in early August. The microlender was suspended from trading, placed under curatorship and split into a good bank and a bad bank. While the final outcomes for investors are still unclear, measures to date include a 10%-haircut and maturity extension on senior debt, and the apparent complete loss of capital on subordinated debt. Coronation did not hold any Abil debt in our bond funds as we did not believe the returns offered enough compensation for the risks involved. However, Abil caused significant reverberations throughout the SA capital market: some bond funds were forced to either record losses or "side pocket" their Abil debt and some money market funds "broke the buck". This dealt a blow to confidence, causing a widening in credit spreads, particularly in bank funding.

While the weakening in bonds and, especially, the currency should have removed most of the valuation concerns, we remain cautious about a more extended period of weakness in bonds and currency markets. The currency is probably, at worst, fairly valued at current levels and one would expect that this could - finally - assist in a recovery of the trade account, particularly once mining and manufacturing production stabilise following industrial action. Inflation should start to top out soon as lower food and oil prices begin moderating the numbers (although this is also critically dependent on rand moves). However, some concerns remain. The Medium Term Budget Policy Statement due near the end of October will be closely watched. Hopes of fiscal consolidation may be disappointed if Eskom and SAA receive more state support. There are also lingering worries about public sector wage talks and the resulting wage settlement. Concerns over the size of the deficit (and the associated bond market funding) will be heightened amid uncertainty over the extent to which SA can still rely on foreigners to help fund it, especially ahead of expected Fed tightening next year. Moving from an underweight to a neutral position in bonds will probably require some noticeable improvement on one or both of the twin deficits. The risks are now more evenly poised: looking ahead, there are no indicators that would imply sharp moves either higher or lower in bonds. Consequently, returns on bonds are likely to largely match their yield.

Portfolio managers
Mark le Roux and Nishan Maharaj

The fixed interest market extended its positive run in June, with the All Bond Index (ALBI) gaining 0.95% for the month and 2.5% for the quarter. Inflation-linked bonds (ILBs) outperformed with a return of 1.39% in June, and 5.9% for the second quarter as a whole, while cash lagged with a return of 1.45% for the quarter. Over longer time periods, ILBs have had a stellar run; the 6-month return of 7.6% and 12-month return of 12% outpaced that of vanilla bonds (3.4% over 6 months and 5.4% over 12 months) and cash (2.83% for the 6 months and 5.53% for the 12 months).

Geopolitical developments added to market uncertainty during the quarter. The Ukrainian conflict took centre stage earlier in the three-month period, while renewed unrest in Iraq continues to threaten security of oil supply. Meanwhile, data coming out of the US suggests a continued recovery in the labour market, while inflation has also surprised on the upside. However, negative GDP data from the first quarter shows that the US recovery is not a foregone conclusion. Nevertheless, the US Federal Reserve (Fed) has continued to taper its asset purchase programme, with monthly purchases now at $35 billion. At this pace, quantitative easing (QE) should end in October 2014, with most Federal Open Market Committee (FOMC) members expecting the first Fed funds rate hike in the second half of 2015.

Against this global backdrop (along with local developments), the rand weakened slightly to end the quarter at R/$ 10.64 (compared to R/$ 10.53 at the end of the first quarter). This came despite foreign bond inflows of R13.8 billion during the quarter - a reversal from the R28.6 billion in outflows recorded for the prior threemonth period. The yield on the benchmark R186 bond declined over the quarter, falling from 8.39% to 8.31% (smaller than the decline in the US 10-year Treasury yield, from 2.72% to 2.53%).

Local events and data releases were at best mixed. While the current account deficit for the first three months of the year showed a surprise narrowing to 4.5% of GDP, the reason behind the compression (large foreign dividend receipts) is probably a onceoff, and suggests that the deficit is likely to widen again. The trade account remains in deficit territory, with the year-to-date deficit already R13 billion wider than that of the comparable period in 2013. While the resolution of the five-month long platinum strike is encouraging, it may take a few months before full production is restored. Coupled with the strike in the metals and engineering sector, the outlook for the current account in the near term is not comforting.

Meanwhile, Standard and Poor's (S&P) downgraded the SA sovereign [foreign currency] credit rating to BBB- (one notch above sub-investment grade) and moved its outlook from negative to stable. S&P notes that the current rating and outlook reflect the adverse local fundamentals; therefore the risk of further downgrades by the agency is limited (but not zero). Furthermore, the local currency rating, which is used for World Government Bond Index inclusion, sits at BBB+ (two notches above the foreign currency rating and three notches above sub-investment grade). On the other hand, Fitch affirmed its rating at BBB (one notch above S&P), but changed its outlook to negative. It is not inconceivable that Fitch could downgrade SA to bring it in line with S&P's rating over the next year or two, especially if signs of fiscal consolidation do not strengthen by the time of the Medium-Term Budget Policy Statement (MTBPS) in October this year or the Budget in February 2015.

The South African Reserve Bank (SARB)'s Monetary Policy Committee (MPC) again kept the repo rate unchanged in May. However, the MPC has re-iterated that SA is in a tightening cycle, so further rate hikes are likely. With May's inflation print at 6.6%, the SARB's credibility will likely be a consideration when the MPC meets on 17 July. Though inflation expectations were unchanged in the Bureau for Economic Research (BER)'s second quarter survey, increasing headline inflation will likely filter through to expectations in coming quarters, and the SARB could move ahead to contain expectations. However, given the weak growth backdrop, the hiking cycle should be a moderate one (a point the SARB has been at pains to emphasize). Furthermore, the MPC has also communicated that the pace of tightening will take into account policy normalization in developed markets; with the Fed only expected to start hiking rates in the US in the second half of 2015, hikes by the SARB are unlikely to be front-loaded, nor sizeable (25bp moves cannot be ruled out). Broadly speaking, SA fundamentals appear to have reached a trough. While the outlook does not necessarily see a sharp improvement, the likelihood of a further deterioration in fundamentals is limited. At current levels, both the currency and domestic bonds appear to have the bad news priced in, suggesting that the trajectory in bond yields going forward is likely to be sideways.

Portfolio manager
Mark le Roux and Nishan Maharaj

Fixed interest assets returned to positive growth in December, after experiencing a tough time in the preceding month. However, the performance of vanilla bonds for the quarter as a whole was still marginal, with the All Bond Index (ALBI) returning 0.1%, while cash returned 1.3%. Inflation-linked bonds (ILBs) outperformed, increasing by 2.8% between October and December. Overall, 2013 was a poor year for fixed interest assets, with the annual return for the ALBI coming in at 0.6% (vs. 16% in 2012), while ILBs were slightly better at 0.8% (vs. 19.4% in 2012). Both asset classes lagged cash, which returned 5.32% for the year.

In this tough year for fixed interest assets, the fund produced a positive return of 1.46%, which was comfortably ahead of its benchmark (the ALBI) over the period. Money Market (local c

The dismal performance of the fixed interest asset class was driven mostly by one factor - expectations around quantitative easing (QE) tapering. After the initial announcement in May 2013 by the US Federal Reserve (Fed) that they intended to scale back their QE programme, and the subsequent speculation on the timing thereof, the Federal Open Market Committee (FOMC) finally announced in December 2013 that tapering would commence in January 2014, with monthly asset purchases reduced by $10 billion (to $75 billion). This followed a few months of better than expected employment reports.

However, despite the start of QE tapering, the Fed statement contained what were deemed to be dovish comments relating to a delay in short-term rate hikes. In essence, while the Fed allowed long-term rates to drift higher, the committee expressed that short-term rates would remain lower for even longer should the economic recovery not gain traction. Subsequent to the tapering decision, the yield on US 10-year Treasuries increased further, touching the 3% handle.

Locally, the fourth quarter saw a reversal of foreign flows into the local bond market, surpassing the outflows seen at the height of uncertainty in the second quarter. Non-residents were net sellers of R16.4 billion worth of South African bonds (from being net buyers of R14.8 billion in the third quarter). This was the largest outflow from the local bond market since the fourth quarter of 2010. As a whole, calendar 2013 saw just over R1 billion in foreign flows into domestic bonds - a far cry from the R85 billion recorded in 2012.

With the net selling by non-residents during the quarter, the rand weakened further, ending the three-month period at R/$ 10.49, compared to a level of R/$ 10.03 at the end of the prior quarter. Over the course of the year to December, the rand weakened by about R2 against the US dollar, having opened the 12-month period at R8.50/$. Given the flows and currency backdrop, local bond yields rose further during the quarter, with the yield on the benchmark R186 ending the quarter 30bps higher than at the end of the third quarter.

Turning to local fundamentals, third-quarter data for the current account showed a further deterioration to 6.8% of GDP, from 5.9% in the second quarter. While not the sole reason for the deterioration, the 8-week long strike in the automotive sector did not help matters. On the other hand, there was an increase in foreign direct investment (FDI) in the third quarter - a welcome development given South Africa's reliance on portfolio flows to finance the current account deficit. As highlighted previously, we believe that the end of cheap money will make it increasingly difficult for South Africa to attract foreign flows, given the challenging state of our fundamentals. Diversification away from portfolio flows to less volatile types of foreign flows, like FDI, would help alleviate pressure on the currency.

Meanwhile, the Minister of Finance tabled the Medium-Term Budget Policy Statement (MTBPS) in late October. While methodological changes led to a narrowing of the projected budget deficit for 2013/14 (from 4.6% to 4.2% of GDP), consolidation in public finances has been pushed out (again) by a year. However, the commitment to fiscal restraint announced by the Minister, including the expenditure ceiling and the cutting of perks to Cabinet shows a willingness on the part of the authorities to address the challenges SA inc. faces. Going forward, the growth outlook and its implication for government revenue collection will be critical in addressing the budget deficit.

Third-quarter GDP data was also released during the past quarter. The automotive sector strike mentioned above negatively impacted the manufacturing sector, with an overall negative impact on GDP. Growth of 0.7% was recorded for the third quarter, putting the year as a whole in line for growth in the region of 2%. Meanwhile, after breaching the upper end of the target band in the third quarter, inflation dipped back within target in the first two months of the past quarter, with November's print at 5.3%. While this inflation print is likely to ease the pressure on the Monetary Policy Committee (MPC) to begin tightening policy, the volatility in the external environment and its impact on the rand have seen the South African Reserve Bank (SARB) strike an increasingly hawkish tone in recent meetings, with the underlying message (in our opinion) that if a weakening rand threatens the inflation outlook, interest rates will have to be hiked.

We remain cautious going into 2014, in spite of the meaningful correction in bond yields in 2013. We are of the opinion that domestic yields are now closer to what we believe to be fair value; however, with the QE taper already in effect, we think that foreign investors will be more discerning of domestic fundamentals when investing in emerging markets. We do not see a (meaningful) narrowing of the twin deficits over the next year, and we expect the wide current account deficit to continue to put the currency under pressure.

With the rand now on the wrong side of R10.50, we see inflation threatening the upper end of the target once more towards mid-year 2014, presenting the MPC with the tough decision of having to raise rates in order to anchor inflation expectations. As a result of this less than favourable domestic picture, our funds continue to be defensively positioned.