Market review
In May the markets were spooked by the possibility of sovereign default by the one of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). The ensuing risk aversion led to a sharp sell-off in the euro and other risky assets. Governments in Europe responded by promising to cut deficits, which would further jeopardise the recovery. The local bond market sold off on the back of the softer currency and weak emerging markets in general, but by the end of the month bonds had bounced off their worst levels. Over the quarter, longerdated bonds underperformed cash, while shorter-dated bonds fared better, matching cash returns. The All Bond Index (ALBI) returned 1.1% over the quarter, while cash gained 1.7%. Listed property rose 0.6% over this period. Year to date, listed property remains the best performing asset class (10.6%).

Portfolio review
The Investec Diversified Income Fund's return was in line with the return of the ALBI (1- 3 year) Index and cash over the second quarter. The fund was well ahead of the ALBI over this period. Economic data released at the beginning of the quarter pointed to a strong recovery, with the Purchasing Managers Index well above 50 and vehicle sales growing at a +30% rate on a year-on-year basis. However, as time passed activity data started to moderate. Credit growth has stabilised but remains relatively weak, raising concerns about the sustainability of the recovery. The South African Reserve Bank kept interest rates at record lows, signalling that it is more concerned about the strength of economic growth than any upside risk to inflation posed by wages or administered prices. Fundamentals for the bond market remain sound. Inflation is surprising on the downside and the fiscal picture is improving with expenditure coming in below budget. The release of the South African Reserve Bank's Quarterly Bulletin revealed a strong bounce in household consumption, underpinned by robust real income growth. Fixed investment was weak, but the economy is forecast to grow by around 3.2%.

Portfolio activity
The market has largely been driven by foreign investors as they must invest the capital flowing into dedicated local emerging market debt funds. However, the wave of buying has not been without its hiccups as sentiment and risk appetite have varied greatly. During the quarter we increased the portfolio's exposure to bank credit and in particular to bank floating rate notes.

Portfolio positioning
The theme for the bond market remains unchanged; rates will stay lower for longer. Not only are local fundamentals supportive, but the shaky fiscal position of developed markets is resulting in large flows into emerging market assets. Yields on South African bonds stand out as being particularly high when compared to other emerging markets of a similar credit rating. This should help South Africa attract its fair share of portfolio flows. Corporate bond yields have compressed significantly relative to government bonds, but still offer attractive returns. We will maintain our investments in these assets for now. The portfolio is conservatively positioned owing to its capital preservation bias. We think bonds will provide a reasonable return owing to their yield advantage over cash. Currency volatility allowed us to increase the foreign exposure of the fund at favourable levels.