Market review
Fixed income markets had a roller coaster ride this quarter as we experienced huge swings in yields. In April, the South African bond market had a big rally that saw the best monthly return for the All Bond Index since July 2010. The rally was driven by foreign flows after the Bank of Japan announced an extremely aggressive stimulus package designed to promote economic growth and inflation. This announcement, together with weaker economic data from China and continued evidence of a slow recovery in the US, led to emerging market bond yields reaching record lows. In May, there was a complete reversal of the exuberance experienced the previous month. Bonds had one of the worst months in over a decade, as rand weakness caused some aggressive selling in our market. There was a global sell-off in bond markets as investors came to terms with improving developed market economies and the prospect of the US Federal Reserve (Fed) scaling back its quantitative easing programme (QE). Emerging markets saw yields rise and most of their currencies lost ground to a strengthening US dollar. This triggered some selling of South African bonds by foreign investors to the tune of R4.7 billion. It is interesting to note that this was the first time since last May that foreigners were net sellers on a month. We expect these investors to remain cautious of the asset class and yields are likely to remain elevated for the next few months. There was also a sharp correction in short-dated yields as the monetary policy committee indicated that rates were likely to remain on hold at current levels for some time. While this was in line with our view, some investors had expected a rate cut, which resulted in these rates being too low. The South African Reserve Bank (SARB) remains extremely worried about the country's slow growth rate and would like to ease rates to stimulate some growth. However, the Bank is equally concerned about inflation, which is close to the upper limit of 6%. Bond markets remained under pressure in June as economic data in the US continued to point towards stronger growth. This led to bond yields rising globally as investors changed their asset allocation. The standout feature was the catch-up in real yields as inflation-linked bonds experienced their worst month since their introduction into the South African market in March 2000. This is part of the global re-pricing of rates, now that the Fed has indicated that its $3 trillion QE programme could be scaled back later this year. Rates are thus "normalising" to reflect the fundamentals. This has sparked a general sell-off, leaving cash as the only fixed income asset with a positive return on the quarter. While the sell-off in yields has led to negative returns for some bond funds, it offers opportunities for the more defensive funds. Yields are now more realistic and are offering a reasonable return for investors. Risks still remain, but it is prudent to start looking at investing some of the cash in our funds in the shorter-dated bonds. On the monetary policy front, we expect rates to remain on hold for the next 12 months as the SARB remains conflicted between rising inflation and the weak economy. Given ongoing rand weakness, we expect inflation to breach the upper band of the inflation target in coming months. It could even remain outside the targeted band for the remainder of the year. As inflation adjusts for the weaker rand, we will continue to see cash generating a below-inflation return for 2013.The rand will remain key, and any recovery from the current "cheap" levels will be welcomed by the SARB.

Portfolio review
We avoided the pitfalls in the bond and inflation-linked bond market and the Investec Diversified Income Fund generated a return ahead of cash over the quarter. The performance was helped by the allocation to foreign exchange, particularly the US dollar. The foreign exchange strategy of the fund reduces the overall risk as it hedges out some of the duration risk in the portfolio.

Portfolio positioning
The portfolio has done well over the cycle. It has benefited from the fall in yields over the past few quarters and we have now reduced the interest rate risk as yields start to rise. Corporate yields remain attractive and the portfolio continues to hold these instruments. As yields continue to rise, we will look for opportunities to invest some of the cash to increase the yield. This portfolio has the flexibility to perform well in all market conditions.

Market review
After the strong performance in 2012 for emerging market bonds, some calm returned to the South African bond market. The year started with a brief bond rally, but yields soon drifted up as investors started to worry about the weaker rand and the prospect of higher inflation. The South African Reserve Bank has become more neutral in its outlook as its tries to balance the slow growth in the economy with rising inflation. The latest CPI number is now at 5.9% and market participants are nervously watching to see when it breaches the upper end of the inflation target. Domestic growth has not yet recovered from the general global slowdown and the SA-specific strike action we experienced in the latter part of last year. These factors have all contributed to a more balanced tone from the central bank and interest rates are likely to remain on hold for the remainder of the year. The rand continued to weaken against most currencies. Labour unrest and discussions around nationalisation were followed by a huge fall in export revenue, which caused the current account deficit to balloon. This saw the rand weaken to R9.25 against the US dollar in March, the upper end of our expected range and somewhat overdone in the short term. We expect the currency to trade within a range of R8.75-R9.25 versus the US dollar. There was little room for positive surprises in February's National Budget. Revenue numbers were revised down, increasing the budgeted deficit slightly for the coming year. Slower revenue has resulted in National Treasury increasing the weekly bond auction issuance by R250 million per week. Globally, the data remains mixed with the US showing some signs of recovery. Europe continues to be a laggard and the focus has now switched to Cyprus. Asian growth is ticking along and the outlook is for a steady recovery from the emerging markets in the region. Japan has lost patience with years of no growth and deflation, and we have seen an aggressive shift in policy to create inflation and boost growth. The steadily weakening rand, coupled with some signs of economic recovery globally has led to foreign investors being somewhat more cautious on SA bonds. The All Bond Index gained 1% in rands over the quarter, while cash, as measured by the STeFI Composite Index, returned 1.2%. Inflationlinked bonds gained 1.8% over the review period. As inflation adjusts for the weaker rand, we will continue to see cash providing a sub-inflation return for 2013.

Portfolio review
The Investec Diversified Income Fund had a good quarter, producing returns well ahead of bonds and cash.

Portfolio positioning
The fund is well positioned for a slight pullback in bond yields. We added more duration to the fund by buying higher yielding short-dated government bonds. These instruments are now offering a higher yield than cash. Corporate debt remains very attractive with the higher yield, and we added some new instruments to the portfolio over the quarter.

Market review
The bond market ended 2012 on a strong note, as yields rallied close to the lows experienced earlier in the year. This helped the All Bond Index (ALBI) deliver a stellar return of 16%, exceeding both cash and inflation by 10%. The bond market's performance was mixed in the last quarter after delivering negative returns in October. Markets were jittery amid strike action and indecisive political leadership. December saw a good recovery in bonds as the ALBI returned 2.6% for the final quarter, which was double that of cash. The macro environment also deteriorated, with exports declining sharply. This led to a problematic current account deficit of 6.4% of GDP, which put further pressure on the rand. Despite the negative news, December saw both the rand and bonds rally, as foreign flows picked up momentum again. There were record inflows of close to R90 billion into the bond market in 2012. This is more than double that of any previous year, as foreign central banks continue to run very loose monetary policies to try and stimulate global growth. These actions have created billions of dollars of 'spare' capital that needs to earn a yield, and hence the sharp rally in emerging markets around the world. Investors have not been discerning enough in respect of the different emerging markets and have instead spread their exposure across these markets. This could lead to added volatility and risk when there is an economic upturn.

Portfolio review
The Investec Diversified Income Fund delivered a solid performance over the quarter, despite the rand strengthening against the dollar in December.

Portfolio positioning
Inflation returned to the South African Reserve Bank's targeted band in May, which allowed the central bank to cut rates to multi-decade lows. We ended the year with CPI around 5.6% and while we expect inflation to rise slightly from here, it should remain subdued in 2013. Hence, rates are likely to stay at these low levels over the next 12 months and there remains a small possibility of a further cut, should global growth deteriorate further. Despite CPI behaving very well, inflation-linked bonds (ILBs) have been the best performer this year. These bonds have rallied to all-time lows (in yield), not so much because of inflation fears, but a continuation of the search for yield. Many investors (local and foreign) have bought these instruments as protection against potential spikes in inflation in the future. Liquidity in these instruments is very low, and yields have been driven down. In some of the short-dated ILBs (with negative yields) investors are likely to underperform cash, unless the yields continue to rally. Global inflation continues to surprise on the low side, which could well lead to slightly lower inflation in South Africa in the second half of 2013. While government funding has increased substantially of late, causing the yield curve to steepen, foreign investors have bought most of the increased supply. The premium demanded for holding long-dated bonds over cash is at multi-year highs. This is likely to remain elevated as government revenues will continue to disappoint in light of the slowing economy. Rating agencies Moody's and Standard & Poor's have both downgraded South Africa's credit rating and they have kept the outlook as negative, which is a concern. This increases the likelihood of further downgrades in 2013. While these downgrades weren't reflected in the pricing of bonds and ILBs, the rand weakened over the year. It was one of the worst performing currencies in 2012. The rand has been the 'pressure valve' for the poor local macro data and will continue to be very volatile going forward. While the rand is now trading closer to 'fair value' at around R8.60 against the US dollar, we could still see further weakness if the euro area has another wobble. We expect the currency to trade between R8.35 and R8.75 for the first 6 months of the new year. We remain concerned about the currency going forward and have a decent exposure to foreign assets. The portfolio remains fully invested in shorter-dated bonds, both government and corporate. These bonds are likely to deliver a superior return to cash, as central bankers maintain rates at very low levels. Corporate bonds offer very good protection, as the superior yield delivers a good return without us taking on too much interest rate risk.