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 Investec Gilt Fund ended the quarter slightly behind the All Bond Index. We were cautiously positioned at the beginning of the quarter on concerns of rising inflation and the possibility of a weaker rand. Despite these factors playing out, the strong inflows from foreign investors in August saw bond yields rally aggressively, but this was partially reversed in September. We have maintained a short duration position in the portfolio and we have increased our underweight holding in long-dated bonds. This area of the curve is likely to remain under pressure.

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%. 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 Gilt Fund performed well over the quarter due to the overweight duration position. The bond holdings were also concentrated around the longer end of the curve, which was the best performing area. As yields rallied, we reduced the bond exposure and now have an underweight duration position in the portfolio. We expect yields to increase from here as foreign appetite diminishes and inflation continues to rise to the upper end of the band. Due to the sluggish growth, the South African Reserve Bank (SARB) will be slow to act on rate hikes, so we have concentrated the holdings on the shorter-dated bonds. Corporate bonds are still expected to give a decent return and we have allocated around 44% of the portfolio to these instruments.

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.

Market review
The bond market started the year on the back foot as inflation fears drove yields higher. The yield curve also steepened due to foreign selling and large government issuance going forward. The political uprising in North Africa and the Middle East pushed oil prices higher, compounding inflation fears.

The South African Reserve Bank (SARB) left rates unchanged and revised its inflation forecast upwards. The short end of the market moved from pricing in a possible further rate cut to expecting the first rate hike by as early as July this year. The rand weakened aggressively in January as local institutions increased their foreign investments in line with the new guidelines set by the SARB. At the same time, the Reserve Bank was very active in accumulating foreign reserves. The local unit was the weakest emerging market currency over that period, depreciating to R7.33 against the US dollar.

The national budget, announced in February, was also disappointing. The budget deficit for the next three years widened slightly and there appears to be little improvement in the amount of issuance. Revenue for the year going forward was revised down. This might turn out to be a conservative estimate, but remains a negative for now. After a poor return of -2.1% in January, the bond market is slowly trying to claw its way back. The All Bond Index returned -1.6% over the first quarter of the year.

Listed property, highly sensitive to the bond market, also gave up some of its 2010 gains, closing 2.2% weaker. Commercial property fundamentals remain under pressure, though highly dissimilar across regions and asset type. A recovery in growth, coupled with a lagged onset of new supply, will lend support to the market over the next year. Cash, as measured by the STeFI, provided a steady 1.4% over the quarter.

Portfolio review
The Investec Gilt Fund's performance was affected by the aggressive sell-off in the longer dated bonds in January and the portfolio delivered a negative return over the quarter. We held the view that the sell-off was not completely justified and thus used the opportunity to increase the duration of the portfolio. We concentrated the buying in the longer end of the curve as the yields at this point were the most attractive. Bond yields are currently offering over 3% above cash. These yields should recover somewhat in the short term. We will then use the rally to shorten duration in the portfolio.

Portfolio positioning
Foreigners are once again adding exposure to our higher yielding bonds. We will need to see these flows sustained in order to regain all the lost ground, as local fund managers remain negative on the market. The SARB has slowly started to prepare the market for a change in interest rates and we are likely to see the first hike in November, but it could be as early as September if global oil and food prices continue to move higher. The global environment remains fluid as Europe considers rising inflation and debt problems in the southern region. Each month has seen another country apply for a bail-out package. The US is continuing with quantitative easing, which is weakening the US dollar and putting pressure on most emerging markets as their currencies strengthen. Various forms of intervention have been tried, with no success. The European Central Bank is expected to hike rates as early as April, followed by the Bank of England in May. The US Federal Reserve is likely to delay raising interest rates to the fourth quarter of 2011. This disparity has further weakened the US dollar and the rand has recovered its losses from earlier in the year.

Market review
The South African Reserve Bank's (SARB) monetary policy committee cut the repo rate by another 50 basis points over the quarter to an all time low of 5.5%, as inflation continued its downward slide. Furthermore, the SARB revised down its already benign inflation estimates, now comfortably within the target band over the full forecast period. The Bank also expressed concern about the sustainability of the local recovery and sovereign debt problems in peripheral Europe. Despite positive domestic inflation fundamentals, local bonds could not shrug off the global bond sell-off, ending up only 0.7% over the quarter. Cash, as measured by the STeFI, returned 1.6% for the three months to the end of December. The best performing asset class over the past year was the listed property sector. The sector continued to show strong returns, despite weak property fundamentals. Listed property gained 3.1% in the fourth quarter to rise by 29.6% for the year.

Portfolio review
The portfolio performed in line with the All Bond Index for the three months to the end of December. The quarter started well with a positive national budget from the minister of finance showing that the fiscal position was healthier than originally forecast. The strengthening rand and lower inflation numbers also gave the SARB scope to cut rates further. The South African macro picture was looking very good. Unfortunately, the global risk environment trumped these factors when Ireland had to go to the European Central Bank for assistance to prevent their banking system from collapsing. Consequently, investors withdrew partially from emerging market debt markets and yields moved higher. December saw some calm returning to these debt markets. We thus experienced a quarter where the short end of the curve rallied, but the very long-dated bonds actually gave a negative return.

Portfolio activity
The portfolio was well positioned for the rate cut, but was then hurt by the risk aversion trade in November. We used the sell-off in yields to increase the duration of the portfolio as bond yields are now yielding nearly 3% more than cash. (Such spreads were last seen in 2004). We continued to look for opportunities to increase the overall yield in the portfolio and bought more corporate paper over the quarter. This is still the most attractive investment for the portfolio, given low cash yields.

Portfolio positioning
The South African bond market is still offering good value with ten-year yields around 8.3%. The alternative of cash at 5.4% is not very attractive. However, we are plagued by the global uncertainty and have not taken on too much risk. We are happy to wait for an improvement in risk aversion before we add more bonds to the portfolio. The rand continues to astound the sceptics as it strengthens to levels last seen at the beginning of 2008. Emerging markets continue to attract capital as the "old" developed world looks to diversify away from the more risky economies. While bonds enjoyed the inflows for the first three quarters of 2010, the trend now clearly favours the local equity market.