In recent weeks, the US and European financial institutions have experienced unprecedented turmoil in the money markets in which they operate. The US Federal Reserve and Treasury, the Bank of England, the European Central Bank, and national Treasuries are all stepping-in, to provide capital (or a rescue plan) to institutions that have had difficulty receiving daily funding. This is in a market which is in a gridlock and hoarding cash. In some cases, banks have been bought up or nationalised, and in others depositors' funds have been guaranteed by the respective central banks.

We draw your attention to our view that this is very much an offshore banking problem, something from which South African banks have been largely protected. The primary reason for this is the existence of SA Foreign Exchange Controls which prevent local banks from participating aggressively in the broader international banking environment. The controls have also ensured that most of the SA banks' funding is from SA sources, which has prevented their liquidity from being threatened by nervous international funders.

The SA Reserve Bank requires that SA banks be well capitalised and that international banks operating in SA do so as a full branch of the parent company, where all local deposits are fully guaranteed by the parent. Further to this exchange controls also prevent these banks from placing excessive amounts of SA depositors' cash in the international arena.

We are comfortable that the SA banks are sound. They are not experiencing funding difficulty and are most unlikely to suffer the same problems as their international counterparts are currently undergoing. It is also important to note that the SA banks carry a strong support rating by the SA Reserve Bank.

The Coronation Strategic Income Fund has weathered the financial markets storm relatively well, with its high exposure to SA banks in the money market contributing to the fund's overall yield to maturity of 11.5%.

During the quarter the fund's duration was kept just short of benchmark duration, given the market volatility. Bond exposures, made up of corporate bonds accumulated at the higher spreads, fared well as bonds rallied after reaching a high of 10.85%. During September we introduced the African Bank bond (1% of portfolio) at a spread of JIBAR+300bp and sold the Old Mutual bond on concerns around the US life business, which appears to be caught up in the global turmoil. The portfolio holds no RSA bonds as we see better value in the corporate sector and have a holding in floating rate bonds, which offer a good spread over JIBAR, the reference rate to which yields reset each quarter. At first glance of the above chart, the strong bond market despite a weaker currency (with its inflation implications), may seem odd. However, it bears similarities to September 2001, when bonds strengthened despite a weakening rand - seemingly the only refuge for exchange control-constrained fund managers against a background of sharp equity weakness. Of course, a few months after 9/11 we saw a very sharp and nasty retracement in bond yields, but that did follow further sharp rand weakening and a change in expectations about SARB rates from further cuts, to hikes. None of these factors are what we currently expect.

There is perhaps a mitigating factor this time around - and that is that even with the sharp fall in the rand that we have seen over the past few weeks, the fall in commodities has offset that. For example, notwithstanding the petrol price reduction in October, there is still an over-recovery currently recorded. The inflationary implications of the rand's fall this time are being offset (thus far) by declines in commodity prices (including food prices). At the moment we still expect to see interest rate cuts from the second quarter of 2009. However, the fact that bonds have run so far despite the increase in risk does make us cautious on the near-term outlook.

While we have been saying for some time that bonds offer value on a long-term basis, the sharp moves over the past quarter have, in our opinion, more than priced that in. We do not feel that the market is adequately pricing in the short term risks and bonds are now looking overvalued.

We have been slowly adding to the property holdings of the fund (currently at 3.4% of portfolio), by introducing selected stocks such as Resilient, Redefine Income Fund and Growthpoint into the mix. These stocks are expected to produce above average returns for the sector over the next few years. The fund currently holds no securitisation assets.

We have always held the view that securitisation was largely overpriced and did not compensate investors for the associated uncertainties, risks and lack of liquidity. We were well rewarded for staying away from this market as prices fell sharply once interest rates rose and spreads widened. We continue to approach this market with extreme caution and during these volatile times are especially averse to the risk that certain securitisation may pose.

Preference shares, with ABSA being the largest holding, are an ongoing holding in the fund. The ABSA preference share is yielding 11.8%. The Coronation Strategic Income Fund continues to be conservatively managed with the main focus being on generating yield and managing interest rate and liquidity risk. The fund returned 4.97% for the quarter.

Mark le Roux and Tania Miglietta
Portfolio Managers

The past quarter can only be termed as the bad news quarter, which came through in big waves, bringing with it higher price volatility and ever decreasing confidence. Compared to a year ago, there is not much to be happy about. But knowing that markets work in cycles and always bounce back, the current market presents a great buying opportunity for long-term investors.

Bonds sold-off in dramatic fashion over the quarter as inflation worries escalated. The All Bond Index lost 4.9%, and 6.7% for the year-to-date. The R157 (2015 maturity) opened the quarter in April at 9.2% and sold-off with the yield to maturity moving all the way up to 10.85% - levels not seen since 2002. The benchmark for the Coronation Strategic Income Fund returned -1.3% for the quarter versus the fund which outperformed with a return of -0.15%. The safest place to be this quarter was in cash.

We saw the repo rate being raised by a further 1% over the period (0.5% in April and June), taking it to 12%. Short term interest rates have more than doubled since the beginning of this interest rate cycle, with deposit rates now at 14% compared to 7% in 2006.

We undertook a major de-risking exercise on the fund at the beginning of the quarter when it became apparent that interest rates were likely to continue to rise. We switched all fixed rate money market exposure into floating rate investments which act as an interest rate hedge. This had the effect of halving the modified duration of the portfolio from 2 to 1. It also meant that the fund had half the interest rate risk of the benchmark (duration of 2).

With the bond market sell-off, bonds have become increasingly attractive and our fair value models are signalling that value is starting to return to this area of the market. However, given the negative backdrop and the risk of the oil price continuing to push inflation higher, we are erring on the side of caution and await confirmation that we are indeed at the top of the interest rate cycle before adding bonds.

Eskom's price increase for this year of 27.5% was confirmed in June. When factored into inflation, the CPIX forecast peaks at over 12% - clearly a worrying figure. Once again, inflation is a cycle and the ten interest rate hikes to-date are designed to bring down inflation. Economists furthermore expect the decline in inflation to be aided by the 5-yearly re-weighting of the CPIX basket in January 2009.
The rand price of oil is up more than 100% from a year ago. The direct contribution to inflation from oil has been huge, which is quite clearly visible in the petrol price. But the indirect impact of higher oil prices is also notable, take for example the price of maize. Two important inputs into maize production are diesel and fertiliser, both oil by-products which are now causing a renewed surge in the maize price. It would appear that inflation and interest rates will deteriorate further before declining.

Money market rates have topped out but the FRA curve continues to price in a further 1% hike in interest rates (reflected in the 1 year NCD rate of 14%). The Coronation Strategic Income Fund has 62% exposure to these high yielding money market assets.

Preference shares are showing good value as their yields are linked to the prime rate. The ABSA preference share which is a core holding of the preference share exposure is yielding 12.4% non-taxable. We have continued to reduce the property holding in the portfolio, now at 2.1%, having sold off the bulk at the beginning of April. With a maximum possible holding of 10% in property, the fund is heavily underweight property. We will look to increase this as the environment improves and price volatility falls.

The Coronation Strategic Income Fund has a running yield of approximately 11.80% (before costs) and is being managed conservatively during these difficult times.

Mark le Roux and Tania Miglietta
Portfolio Managers

The SA bond market returned 0.9% for the quarter. This lacklustre performance should be seen in the light of more negative surprises on CPIX inflation; two interest rate hikes, an intensification of the credit crunch overseas, and a widening in emerging market spreads. Against that backdrop, the fact that bonds managed a positive return is actually not bad at all! The only really supportive factor was a decline in US bond yields, though that was largely a combination of flight-to-quality bids and fears about US growth, neither of which is particularly healthy for SA. The rand moved largely sideways over the quarter, with a brief spurt of strength in late October/early November proving unsustainable. The all-bond index underperformed both cash and inflation-linked bonds for the quarter and the year.

Each of the three CPIX inflation releases during the final quarter of the year surprised market forecasts on the upside, and the end result was that CPIX had moved up sharply from 6.3% in August to 7.9% in November. This is well above the upper limit of the SA Reserve Bank's (SARB) 3% - 6% target range. The December figure, to be released at the end of January, will almost certainly be well north of 8%. The fact that the driving factors behind the inflation rise remained food and energy added to the SARB's concerns about second-round effects, and the data most probably sealed the decision to raise the repo rate 50 basis points at each of the October and December MPC meetings. The repo rate has now increased by a total of 400 basis points in this cycle.

However, the news was not all bad from an inflation perspective, and indeed from a forward-looking standpoint there are clear signs of improvement. The rand has generally remained stable (not just over the quarter but throughout 2007) and the lagged effect of this will help dampen CPIX beyond the first quarter of 2008. Indeed, the stable rand has already had something of a positive impact on PPI, and unlike CPIX that has tended to surprise on the downside. PPI is a leading indicator of CPIX trends. Meanwhile, the SARB's other stated concern - consumer spending - has shown signs of a sharp slowdown in recent data, and it can only be a matter of time before this is reflected to an acceptable extent in the credit data.

The SARB continues to find itself in a tight spot, with no sign of pressure easing on food and fuel prices, yet all indications are that more than enough pressure has been brought to bear on consumers. There must be a limit to the extent to which exogenous factors (and here we would include Eskom tariff increases) can drive monetary policy in the face of slumping consumer spending. It may be an opportune time to stick our necks out and say that it is likely time that the SARB will pause at the January MPC to see the effects of previous rate hikes - particularly if it is forward-looking.

The international backdrop will continue to be crucial. There are heightened concerns about growth in certain developed markets, particularly in the US. This could keep US bond yields low. However, if the credit crunch continues, risk aversion may stay relatively high and risky assets may stay under pressure. Capital flows into SA have been a key factor supporting the rand in the face of the wide current account deficit, and the rand could become vulnerable if sentiment towards emerging markets in general turns negative. This will remain a key risk this year. A positive side effect may be that concerns about growth should help alleviate some of the pressure recently seen on oil prices.

From a domestic perspective, the outlook is cloudier in the shorter term than the medium term. CPIX is expected to remain elevated in the first quarter, but should begin declining meaningfully from the second quarter and should slip back inside the target range by the third quarter. Coupled with what we expect to be continued evidence of a consumer slowdown, this should provide space for interest rate reductions in the second half of this year. This more positive outlook for bonds is again predicated on the assumption that any depreciation in the currency will be moderate, and is again held hostage to developments in oil and food prices. While the medium term outlook is basically positive, therefore, it remains fraught with risks and the SARB is likely to remain cautious. This fundamentally positive outlook tempered by a number of risks probably argues for keeping duration fairly close to the benchmark at present.

Interest rates in SA have been rising for the last 18 months. In this environment we aim to protect capital as much as possible by reducing exposure to the longer duration assets such as bonds and property and investing the proceeds into cash. When we believe the rising cycle has topped out, we will reverse this action by increasing duration via bonds and property. In June 2007 the portfolio held no government bonds. We took the view that the top of the interest rate cycle had arrived, and that there was sufficient monetary policy tightening in the system by the SA Reserve Bank to curb rising inflation. Thus we bought some bonds and longer dated money market NCDs locking in the much higher yields on offer (9 - 11% pa for 2 - 3 years). Oil and food prices surged in the second half of 2007, prompting the central bank to continue hiking the repo rate by a further 2%.

We continue to believe that there is sufficient tightening in the cycle to bring inflation back into the target range by the end of this year, thus allowing the MPC to begin the process of reducing interest rates towards the end of 2008. The portfolio is currently positioned for the top of the interest rate cycle via the large holding in high yielding NCDs and longer maturity bonds. This barbell positioning enables us to achieve a longer modified duration (currently 1.69) without losing out on yield. The portfolio is now yielding 10.3%.

The fund's preference share and property exposures remain unchanged. The fund continues to be managed in a conservative manner, with the main focus on achieving a high yield for investors, taking cognisance of the volatility inherent in the market at the moment and the speed with which the interest rate cycle can turn.

Mark le Roux and Tania Miglietta
Portfolio Managers