Market review
The bond market had a very good third quarter, albeit extremely volatile. Bonds returned 2.8% and cash, as measured by the STeFI Index, gained 1.4% over the review period. Most of the returns for bonds came during the aggressive rally in August, which was followed by a partial retracement in September. The market has been very skittish as it oscillates between hope and fear. The hope is that the European politicians will reach consensus on a rescue plan that will prevent a recession in the region and allow countries enough time to get their balance sheets in order. The fear is that that some countries (mainly Greece) will default and even leave the euro zone. This will lead to major write-downs in the banking sector and thus cause another financial crisis that would tip the global economy back into a recession. Economic releases and statements from central bankers have thus become very sensitive issues that are closely watched by all participants in the markets. The South African market has gone from anticipating an interest rate hike by the end of this year to now pricing in a 40% chance of further easing. This view is largely driven by global factors and not so much local drivers.


Portfolio review
The fund had a very good quarter with a return of 5.8%, largely due to our offshore exposure. Given global risks, we have taken a more conservative position on South African assets. We are maintaining our exposure to higher-yielding corporate assets so as to maximise yield. Duration is being kept low until we are more comfortable with the prospects for Europe. The risks are still for continued upside in yields, if foreigners need to exit the market. We are comfortable with our exposure to the shorter-dated instruments as they will be anchored by the low repo rate. We continue to add to our inflation-linked bonds as the weaker rand should cause consumer price inflation to rise higher than previously thought. We are maintaining our exposure to US dollars and euros in light of the heightened risks of further local currency weakness.

Portfolio positioning
The South African economy is growing rather slowly, partly due to strike action as well as decreasing demand from Europe. This has resulted in expectations of rate hikes being moved out to 2013. The lack of job growth is a concern and the weaker rand will be very welcome to the export sector of the economy. The boost this sector should get will more than likely offset any negative inflation effect. Local demand is still muted and therefore pricing power is limited. We should see inflation breach the upper band of the target within the next few weeks, but we do not expect a sharp acceleration in inflation.

Bond yields have been dominated by foreign flows and have added to the volatility of returns. The steady inflows up to August saw the yield on the R157 (2015 maturity) reach a historic low of around 6.25%. The sharp outflows in September did, however, cause these yields to move up above 7% again. These flows have been the dominating driver over the past few quarters, which highlight the importance of resolving the European debt situation. If politicians continue to dither, investors will keep on withdrawing from emerging markets and we will then see further weakness in both the rand and the bond market.

The South African Reserve Bank will be watching these developments and inflation closely. We don't foresee any further cuts in interest rates, but do expect rates to remain at these low levels for an extended period of time.

Government finances are also under the microscope, as tax collections are running behind budget due to the slow growth in the economy. This has put added pressure on the bond market, especially the longer-dated bonds. The 'mini' budget to be presented by the minister of finance later this month will be closely watched to see if more money needs to be borrowed from the bond market.

Market review
The second quarter saw a strong recovery in the bond market as risk appetite returned to global markets. Quarterly returns for the bond market were 3.9% while cash returned 1.4%. The listed property sector enjoyed healthy gains, lifting total returns to 5%. Emerging market debt attracted large inflows and South Africa was no different. Foreigners bought in excess of R35 billion of our local debt during this quarter and this was one of the main reasons for the rally. These flows have become the dominant driving force of yields. During the review period, yields rallied hard, especially in the long end of the curve, as this is where the buying was concentrated. The rally in yields occurred at a time when domestic inflation rose above expectations and local issuance was concentrated in the longer end of the curve. The carry trade is thus the 'big show in town' and as long as global rates are kept near zero, investors will look to emerging markets for higher yields. This is a risky trade as a sharp currency move could result in larger losses than the carry supplies. The market is thus very skittish and volatility is likely to increase.

Portfolio review
The Investec Diversified Income Fund had a good quarter, thanks to the high exposure to bonds in April and May. We have subsequently reduced this exposure and added inflation-linked bonds and floating-rate notes to the portfolio. We are now cautious of the bond market as local inflation is rising and should be around 6% by year-end. The market is also very vulnerable to foreign sentiment and with all the concerns about southern Europe, there is a chance that investors may reduce risk. South Africa, along with other emerging markets could then see their yields move higher. The range is unlikely to be large as cash rates will be anchored by a dovish SARB. Active management will thus be important over the remainder of the year. While the local currency traded in quite a wide range over the quarter, the actual level was relatively unchanged against the dollar. We used the stronger levels to increase the fund's foreign exposure.

Portfolio positioning
Local fundamentals are likely to deteriorate over the next quarter as inflation continues to rise. This will not be helped by steep electricity hikes as well as high wage demands. Bonds are thus looking slightly expensive at current levels and we are reducing exposure across all our portfolios. The rand remains overvalued due to the large inflows, and we are increasingly concerned that the local currency could depreciate into year-end. A weaker rand will add to the inflation woes and make the South African Reserve Bank (SARB) increasingly worried about inflation. The SARB is equally concerned about the sluggish pace of growth in the South African economy and the absence of employment growth. The Bank is thus likely to hold off on interest rate hikes for as long as possible. This should result in steeper yield curves as investors demand a higher risk premium for holding these instruments.