Market review
The third quarter was dominated by the subprime housing crisis in the United States, widespread credit concerns and the growth prospects of the US economy. The general reluctance of banks to lend to each other was not confined to the US, and global banks saw a severe squeeze in liquidity. A full-blown implosion of the US credit market was narrowly averted when the US Federal Reserve (the Fed) first cut the rate at which it lends to commercial banks and later the benchmark federal funds rate, from 5.25% to 4.75%. Global government bond yields rallied hard from the beginning of July as the markets reacted to signs that policy tightening was starting to impact credit markets.

Domestically, we witnessed a modest slowdown in growth and evidence of somewhat weaker consumer spending, particularly evident in the motor vehicle retail sector. Rising inflation, mostly on the back of sharply higher food prices, and a pick-up in inflation expectations were met by a further interest rate hike in August.

Global events reflected in the SA market, causing bonds and the currency to weaken and equities to sell off as risk appetite waned and uncertainty with regard to the global outlook grew. However, the bears seemed to lose the battle yet again as US Federal Reserve governor, Ben Bernanke, provided some monetary relief.

Equities recovered strongly from their August lows, gaining 6.7% over the quarter. Bond and property yields pushed lower and the currency gained strongly against a falling dollar. Over the quarter the All Bond Index (ALBI) was 3.4% higher, listed property rose by 9.5% and cash (as measured by the STeFI) earned a return of 2.3%.

Fund performance
The Investec Gilt Fund gave a return of 3.2% over the quarter, against the ALBI return of (3.4%). This has been the best quarter for the bond market so far this year. Despite the continued higher inflation and global credit woes, yields have rallied and are anticipating the peak in local interest rates.

The portfolio has been slightly short duration over the quarter and we have bought back some duration. Credit spreads continue to widen and as such we have not increased our exposure in this area.

Performance was helped in July and August by our underweight duration position and we outperformed the index. The aggressive rally in yields in the latter part of September saw us lose some ground to the index. However, we used the sell-off in the listed property market to increase our weighting to these stocks, which performed strongly in September.

Portfolio activity
We traded the duration quite actively over the quarter. We started the quarter being shorter than the ALBI and as yields rose we started accumulating bonds and built a long duration position going into September.

As CPIX continued to deteriorate we sold some duration during September. We also changed our yield curve positioning as we reduced our exposure to the very long end of the curve and bought some more shorter dated bonds. Due to the concern regarding global credit events our participation in local auctions was limited. We bought some NED11 (Nedbank) and SMF2 (Sasol) bonds. We increased our weighting in listed property with buys of Liberty International, Growthpoint Properties, Emira Property Fund and Redefine Income Fund.

We slightly reduced our exposure to credit over this period by selling predominantly bank paper. We also sold ApexHi A and ApexHi C.

Market outlook
The bond market is starting to look through the peak in CPIX inflation and is anticipating the end of this interest rate cycle. Even though inflation is forecasted to remain outside the targeted band of the South African Reserve Bank (SARB) for the next six to eight months, bond yields have already started to rally.

Our view is that inflation will only peak next year and as such there is still a risk that yields will sell off again. The October monetary policy committee decision is too close to call and the SARB governor will hike interest rates if he solely looks at inflation. However, it is expected that he will have watched the global events with concern and may well decide to pause in order to ensure that this credit crisis has indeed passed.

The biggest risk to our portfolio is that the bond market continues to ignore the high inflation and starts to price in the chances of interest rate cuts by the end of 2008. We feel that the bond market has run ahead of itself and that there will be a better buying opportunity during this final quarter. Inflation is going to start rising again and yields should also rise.

Market review
Against a backdrop of steady global expansion and some inflationary concerns, monetary policy risk remains to the upside. Global bond markets sold off aggressively during the quarter, reflecting rising demand for capital and higher real yields. The European Central Bank's tightening bias pushed the euro to reach a series of record highs against the yen while at the same time climbing to two-year highs against the US dollar. The rand strengthened against major currencies over the quarter, in line with both commodity and emerging market currencies.

The domestic inflation outlook has deteriorated over the quarter. Rising yields globally and domestic inflation concerns resulted in the local government debt curve increasing sharply. Over the quarter the benchmark R153 and R157 peaked at 9.15% and 8.58% respectively. Bonds underperformed cash. The All Bond Index lost 1.7% over the quarter while cash (as measured by the STeFI Index) earned a return of 2.2%. The All Bond Index (1-3 years) returned 0.7% over this period. Rising bond yields and deteriorating inflation expectations put pressure on domestic listed property. The sector was up marginally over the quarter (0.3%) but remains firmly in the black year to date at 16.1%.

Fund performance
The Investec Gilt Fund returned -1.7% over the quarter, in line with the All Bond Index. We did start buying back some duration and are now marginally shorter than the All Bond Index. The portfolio benefited from being short duration as well as the positioning on the yield curve. Your portfolio was overweight the R157 area of the curve which was the best performing area.

As inflation expectations deteriorated, both the short end and the very long end sold off more than the middle area of the curve. Credit spreads did not perform well over the quarter and the slight widening of some of the corporate holdings in your portfolio detracted from the overall performance.

Portfolio activity
The portfolio started the quarter with an underweight duration position and a large allocation to cash. As yields rose we slightly reduced the cash holdings by buying up some duration. Most of the buying of duration over the quarter was concentrated in the R157 area as these bonds continue to trade 'special' in the market. This resulted in them outperforming all the other bonds when yields rose. The corporate holdings were kept relatively unchanged and we merely sold some of the more expensive corporate bonds (MTN and ABSA 2010) and bought some of the new bonds that were issued at higher yields (ABSA 2012 and Growthpoint).

Market outlook
The bond market is going to be fixated on the CPIX releases over the next few months. Since we broke out of the official inflation target band, there has been extra pressure on the SARB to hike rates. At present the market is pricing another 50 basis points hike in August and a 40% chance of a further 50 basis points hike in October. This would have seemed excessive a few months ago, but inflation fears have risen in most global economies and we have seen deteriorating inflation expectations across the globe. Real rates globally have also been rising which will keep our rates higher for longer.

The major causes of higher inflation have been food and fuel, but we are starting to experience 'pass through' inflation as retailers pass on these higher costs to the consumer. This together with higher than expected wage increases will keep the SARB vigilant. On the positive side we are starting to see a slowdown in credit demand from the consumer as reflected in falling car and retail sales figures. This will be encouraging to the Governor as he has been warning consumers to reduce spending.

Our short duration position has been reduced and the portfolio is currently neutral to the All Bond Index. We see value in the bond market and as rates rise further we will start to build an overweight duration position. Thus, the biggest risk to our view is that inflation surprises on the upside and the SARB has to hike rates more aggressively. As inflation stabilises at these levels and economic growth continues to moderate, we will see rates settle before rallying into the latter part of the year

Market review
The South African bond market had a difficult month, losing 0.4%, which trimmed the quarterly return to a meagre 1.6%. Cash (as measured by the STeFi index) earned a return of 2.1% over the quarter, outperforming bonds. In the run up to the national budget, bonds priced in so much good news that they became vulnerable to any signs that the rate cycle might not have reached its peak. Credit and trade data suggested that the imbalances in the SA economy might be unusually tenacious. This was enough to convince investors that the monetary authorities might have to keep their finger on the interest rate trigger for a while longer. The rand weakened by 4.1% against the US dollar and 4.6% against the euro over the quarter

Fund performance
The Investec Gilt Fund gave a return of 1.7% over the quarter, outperforming the All Bond Index (1.6%). The fund was reasonably active over this period. We increased the duration of the portfolio in early January in anticipation of a bond friendly budget and the seasonal coupon flows. The Minister of Finance did not disappoint and the unexpected budget surplus and the removal of the retirement fund tax caused bond yields to rally in February. We used this opportunity to reduce the duration and held a more conservative position through March. Bond yields are now substantially below cash yields, thus we have increased our cash position in the portfolio. Performance was helped by active management over the quarter and increasing the overall yield of the portfolio by increasing the cash holdings. Bond yields continue to trade well below cash yields and in March cash comfortably outperformed bonds. The longer dated bonds where thus a drag on the overall yield of the portfolio.

Portfolio activity
There was a great deal of portfolio activity over the quarter as we had two positive months where bonds outperformed cash followed by a negative month. The portfolio could thus increase the duration, and decrease the cash holdings in January and February to benefit from the bond rally. We then sharply reduced the bond holdings at the lower yields in order to protect the portfolio from some of the capital losses in March. Although we did not meaningfully increase the overall exposure to credits over the quarter, we did replace some of the lower yielding credit bonds with some new issues. Credit yields of existing bonds had rallied over the past twelve months; while indications were there that new issues would have to offer higher yields in order to interest buyers

Market outlook
The inflation outlook has deteriorated on the back of rising global oil and food prices. These pressures will ensure that the South African Reserve Bank (SARB) remains cautious on interest rates for the foreseeable future. While there are some signs that consumer demand may be moderating, demand for credit remains at elevated levels. The SARB continues to use every opportunity to 'warn' SA consumers to curb their spending and reduce debt. The risk of further interest rate hikes will persist. If oil prices suddenly moderated and food prices stabilised at current levels, the inflation outlook would improve sufficiently that the SARB could hold off on any further interest rate hikes. This could result in a rally in the bond market and thus our underweight duration position could be a risk. However, the portfolio's underweight duration position will give some capital protection in the event of a sell-off. The large cash holding is also giving the portfolio a higher overall yield due to the fact that bond yields are currently trading below cash yields.

December was a rather quiet month in the bond market and despite the SARB increasing the Repo rate by another 0.5% the ALBI returned a respectable 1.51% for the month. This brought the annual performance up to 7.5% for the year. This has not been a great year for bonds as short term rates have been steadily increasing, but the final quarter of the year has seen a rally in bond yields as the market anticipates the top of the interest rate cycle.

The latest inflation numbers continue to support the view that we are close to the top of the interest rate cycle. CPIX for November came out at 5% and appears to be more muted than previously thought. This increases the possibility that the SARB may well pause at the next MPC meeting.

Our forecast is for CPIX to breach the upper band over the next few weeks, but to top out here and then come down again. This will allow the SARB to pause and wait for the effects of the previous hikes in interest rates to work through the economy. The growth in credit is still worrisome and we expect the bank to monitor this closely in the coming months.

The global market has been muted and we have received very little direction from this front. We have seen an increase in risk appetite, which has seen foreign investors return to our markets. These flows have contributed to a firming Rand over the month.