Market review
Against a backdrop of accelerating inflation, the South African Reserve Bank (SARB) hiked interest rates by a cumulative 100 basis points in April and June. Prior to the June meeting, markets were positioned for a 1% rise after the SARB governor cautioned that tough measures may be needed to bring inflation back into the target band. However, rates were increased by only 50 basis points. The Bank cited evidence of a substantial slowdown in growth as the reason for the lower-than-expected hike in rates. Accelerating global oil and food prices as well as a weaker rand continue to underpin the negative domestic inflation outlook. The National Energy Regulator's recommendation of a 27% hike in the electricity tariff for 2008 and similar increases in 2009 and 2010, will further add to domestic inflationary pressures.

The bond market experienced substantial weakening across all maturities as the yield curve saw an upward shift in excess of 150 basis points over the second quarter. The All Bond Index lost 4.9% over this period, while cash (as measured by the STeFI) returned 2.7%. The listed property sector took its cue from rising interest rates and higher bond yields, selling off aggressively to shed 19.6% in the second quarter.

The All Share Index closed 3.4% up over the quarter losing some of its earlier gains as inflation fears gripped global markets. Substantial dispersion in performance across the sectors was evident as resources gained 13.4% over the quarter, while the Financial and Industrial Index lost 6.4%. General mining led resources higher, closing up 18.1% over the three months to the end of June. Banks and general retailers shed close to 15% over the quarter, while the defensive food retail and telecommunications sectors ended up 3.2% and 3.4%, respectively. The telecommunications sector was buoyed by corporate activity as MTN sought a potential merger with an Indian telecoms company.

Fund performance
The second quarter of 2008 was a tough quarter for the bond market, with the All Bond Index (ALBI) returning -4.9% over the period. The market has now experienced six consecutive months of negative returns. The Investec Gilt Fund earned a return of -4.8% over the quarter, marginally outperforming the ALBI. For the year to the end of June, the fund returned -2.6%, against the ALBI return of -2.7%.

The portfolio was underweight duration throughout the quarter, as we anticipated the sell-off in yields. We started accumulating bonds in the latter half of June as the market reacted to both the worsening inflation outlook and the global risk aversion experienced by emerging markets.

Performance was helped by the underweight duration position as well as the overweight cash holding in the portfolio. However, the overall performance was hurt by the general sell-off in yields as all bonds delivered a negative return over the quarter. Although we had a very conservative holding in corporate bonds, they were nonetheless laggards over the quarter.

Portfolio activity
While we maintained an underweight duration position for most of the quarter, we did add duration to the portfolio as yields steadily rose. We also used the increased volatility in the market to take advantage of some shorter-term opportunities.

We continued to remain cautious on credit over the quarter and did not participate in most of the new auctions. There has been a marked increase in corporate spreads and we have slightly increased exposure to the corporate bond portfolio over the quarter.

We continued to sell down our parastatal weightings by reducing our holdings in Transnet 2010.

Market outlook
The bond market has reacted very negatively to the worsening local and global fundamentals. The global outlook continues to be very uncertain and the inflationary forces are persistent as oil reaches new highs. This has led to risk aversion from foreign investors. SA has been singled out thanks to our large current account deficit, and they have been consistent sellers of our currency and bonds. The rand has been one of the worst performers this year, which has exaggerated the effect of the higher oil prices.

On the local front inflation has continued to surprise on the upside. Not only have we had to absorb the higher commodity prices, but we are now faced with large electricity tariff increases. Concern has been growing about the second-round effects, as local manufacturers have passed on all the increases onto the consumer. This has resulted in CPIX inflation reaching double digits and has forced the South African Reserve Bank (SARB) to continue hiking interest rates.

Consumer demand has finally shown signs of a slowdown across the board, which has now been acknowledged by the SARB. There is a good possibility that we have seen the last interest rate hike in this cycle, however, this view is dependent on oil at least stabilising around current levels. We are about three months from the peak in inflation and should see it start falling into year end. This will be positive for the bond market and as a result we anticipate some recovery in bond returns over the second half of the year.

We continued to add duration to the portfolio as yields rose and we now have an overweight duration position for the first time this year. Should yields continue to rise, this will lead to some underperformance.

However, we believe the bond market has overreacted to the bad news and is in fact overpricing the risks. We may see a rally over the next few months. Therefore, we will remain overweight in anticipation of this rally

Market review
The first quarter of 2008 was dominated by the financial market fallout from a faltering US housing market. Related credit concerns and an interbank market that ceased to function, precipitated aggressive policy intervention over the quarter. A surprise intermeeting interest rate cut of 75 basis points by the US Federal Reserve (the Fed) in January was followed by two further cuts with the federal funds rate closing the quarter a full 2% lower. Economic data remains weak, while the US dollar continues to hover around all time lows against its major trading partners. Global bonds saw strong absolute returns over the quarter, closing 9.7% higher over this period (in US dollar terms). The market ignored inflationary pressures and reacted instead to aggressive policy intervention, decelerating growth and a general risk aversion.

On the local front, bond yields succumbed to continued upward pressure on rising inflation, heightened risk aversion, a sharply depreciating domestic currency and potential further upside risk to monetary policy. The South African Reserve Bank faces rising global food and fuel prices, upward pressure on local electricity prices, as well as a depreciating rand. However, the outlook for domestic demand has deteriorated and monetary tightening in this cycle has not yet fully impacted domestic growth. This poses a dilemma for the inflation-targeting central bank. The All Bond Index lost 1.9% over the quarter with the short-dated bonds anchored by uncertainty about the next policy move, while the longer end sold off on the elevated inflation outlook. Cash (as measured by the STeFI Index) returned a steady 2.6% over the quarter.

Listed property remains under pressure from rising bond yields, rand weakness and some uncertainty with regard to income distributions as the economic outlook deteriorates. The sector lost 10.9% over the quarter, broadly in line with other interest rate sensitive sectors. The economic slowdown, power constraints and rising funding costs are likely to put a dampener on supply of new real estate, benefiting the owners of existing stock. Property fundamentals remain supportive of real distribution growth over the next few years.

The FTSE/JSE All Share Index retraced the losses sustained towards the end of 2007, closing the first quarter up 2.9%. Resources were the clear winners, returning 17.6% as commodity prices reached new highs and earnings were aggressively revised upward. The domestic focused FTSE/JSE Financial and Industrial Index lost 8.5% over the quarter, depressed by tougher trading conditions and poor sentiment towards rate sensitive sectors.

Fund performance
The first quarter of 2008 was a tough quarter for the bond market, with the All Bond Index (ALBI) returning -1.9% over the period. The Investec Gilt Fund earned a return of -1.7%, outperforming the ALBI. For the year to the end of March the fund returned 0.5%, broadly in line with the ALBI.

We maintained a short duration position throughout the quarter to protect your portfolio from the negative sentiment driving yields higher. The bond market is being driven by global risk aversion on the one side and increasing local inflation on the other. Foreign investors have been quick to sell both SA bonds and to reduce their exposure to the rand. Thanks to our current account deficit, we are a capital hungry country and as such have been punished by investors as they look for more secure investments. Inflation continues to surprise on the upside, which is going to make the South African Reserve Bank (SARB) very uncomfortable and increase the likelihood of a rate hike.

The portfolio benefited from the underweight duration position as well as the underweight position in the long area of the curve. This defensive positioning resulted in your fund outperforming the ALBI.

Credit yields continued to widen as the market repriced risk. We had an extremely conservative exposure to credit and have limited our exposure to the higher quality bonds.

Portfolio activity
We maintained a core underweight duration position throughout the quarter, but increased this position as and when the fundamentals deteriorated. As we reduced our risk to longer dated bonds, we switched our exposure to shorter dated higher yielding bonds and to cash. On the corporate front there were some very attractive buying opportunities, as new issues traded well above existing issues.

We bought some African Bank 2013 and Investec 2013. We continued to reduce our overall exposure to corporate debt and have sold Old Mutual 2015, Absa 2015, Absa 202, African Bank 2011, African Bank 2012, Metropolitan 2014 and Standard Bank 2013.

Market outlook
The bond market still faces significant headwinds. Given our large current account deficit we will continue to be vulnerable to further global shocks and the South African Reserve Bank is likely to remain cautious for the next few quarters. Inflation expectations need to be closely watched to ensure that higher inflation does not become entrenched in the broader economy. It leaves very little room for interest rate relief for the remainder of the year. Bond yields may well pause at current levels as markets try to digest all the news. However, in our view yields will rise again as inflation is set to remain stubbornly high.

We remain underweight duration and as such the risk to your fund would be if the rand were to recover meaningfully from current levels, resulting in a rally in bonds.

We have concentrated the bond exposure in the shorter dated bonds, which are paying a higher yield. This, together with our cash holding, offers the portfolio some superior yield protection.

Market review
The US Federal Reserve's key interest rate cuts in the third quarter saw equity markets rally, credit spreads tighten and risk appetite resurface. However, during the fourth quarter much of the upside was reversed. Inflation fears, driven by rising energy and other commodity prices, placed a dampener on more aggressive policy accommodation near term. Policy makers however still have to contend with a decisive slowdown in fourth quarter US growth, a slumping housing market, disappointing retail sales and a credit market that has yet to normalise. Poor earnings - dominated by subprime related write-downs amongst US investment banks - are likely to continue into the New Year. Coordinated efforts by global central banks to infuse liquidity into the global banking system are achieving some temporary relief with the interbank and corporate debt market showing tentative signs of improvement.

On the local front, the bond market focused on inflation data and the near term direction of interest rates. With inflation accelerating and the outlook for food and energy prices deteriorating, the bond market had priced in a fourth interest rate hike in 2007. The South African Reserve Bank's monetary policy committee statement leaned towards a peak in the interest rate cycle and the yield curve shifted down, retracing some of the earlier losses. The All Bond Index returned 0.9% over the quarter and 4.2% for the year. Cash (as measured by the STeFI) returned 9.3% for the year and 2.5% over the fourth quarter.

Domestic equities came under pressure during the fourth quarter, with the All Share Index closing down 3%, but achieving respectable returns of 19.2% for the year as a whole.

Fund performance
The fourth quarter was a difficult one for the bond market. The Investec Gilt Fund earned a return of 0.7%, underperforming the All Bond Index. The combination of continued higher inflation, further rate hikes, local political noise and persistent global credit woes, all combined to push bond yields higher. For the year to December the fund returned 4%, broadly in line with the All Bond Index.

The portfolio was underweight duration from the beginning of the quarter, moving to neutral at the end of November, before reestablishing an underweight position into the year-end. We continued to remain cautious on local credit spreads and as such we have remained conservative in our exposure to this area.

In October, yields ended marginally lower after a volatile month and we performed largely in line with the benchmark. However, in the November sell-off we were well placed with our underweight position and outperformed, using the higher yields at the end of the month to move our positioning to neutral. December was another mixed month, with yields rallying at the start of the month, giving us an opportunity to re-establish our underweight duration position. This helped performance into the year end sell-off.

Portfolio activity
We traded both duration and the yield curve actively over the quarter. The fund started the quarter being shorter than the All Bond Index. As yields rose we started accumulating bonds, moving to neutral at the end of November before re-establishing our underweight position in December. The yield curve disinverted a little in November, before inverting further in December, giving us a trading opportunity to scale back our underweight in the very long end of the curve and then to reestablish it.

Due to the concern regarding global credit events our participation in local auctions was very opportunistic, with an emphasis on liquidity. We slightly increased our exposure to highly rated state owned enterprise bonds.

Market outlook
The outlook for the bond market remains uncertain in the coming months. Inflation has surprised to the upside. The market forecasts for the inflation peak, including our own, have moved higher and further out, dimming the prospects of any easing this year and increasing the risk of further hikes. This is against a backdrop where a sharp slowdown in global growth is a very real probability and the financial sector and liquidity markets remain under pressure.
The recent political developments in South Africa and increased noise that is likely to flow from that are expected to continue well into the year, adding volatility to the fixed income and currency markets in South Africa. We therefore expect bonds to be volatile over the next quarter with a bias for yields to go higher and the yield curve to begin to disinvert.

The biggest risk to our portfolio is that the bond market continues to ignore the high inflation and starts to aggressively price in rate cuts by the end of 2008, as domestic growth slows sharply. Our view is that the bond market will be volatile and that there will be better buying opportunities in the months ahead. Inflation is going to continue to rise in the next few months, while political noise and global risk aversion should help the yield curve disinvert.