Market review
Foreign flows remained the dominant driver for the quarter as investors continued their global search for yield. The South African Reserve Bank (SARB) surprised the market in September with another interest rate cut as the Bank remained concerned about lacklustre local growth prospects. This is a direct result of the continued problems in Europe as well as the below par growth emanating from both the US and Asia. The global policy response came in the form of a third round of quantitative easing from the US Federal Reserve and the announcement from the European Central Bank that it would buy sovereign debt in the region under certain conditions. These measures are aimed at keeping rates as low as possible to encourage growth. China has also been stimulating its economy as growth numbers continue to disappoint. These actions have prompted further investments into higher-yielding emerging markets and South Africa has seen its fair share. Net inflows into the bond market were close to R30 billion for the quarter. Further impetus for flows was also provided by South African government bonds' anticipated inclusion in Citigroup's World Government Bond Index. We have seen record year-to-date inflows of close to R80 billion. With South African inflation subdued for now, the relatively high yields are attracting foreign investors who face near-zero yields in their home markets. These foreign flows are dominating the market and local data has been largely ignored. Bonds added 5% in the quarter to record gains of 13.1% for the year to date. Longer-dated bond yields fell by 50 basis points over the quarter. Cash, as measured by the STeFI Composite Index, added a marginal 1.4% over the quarter and 4.2% for the year to date.

Portfolio review
The bond market's performance can largely be attributed to the large foreign inflows as new investors searched for yield. The demand took yields down to levels that are not sustainable under the current macro environment. The portfolio, which lagged behind the All Bond Index over the quarter, is now well positioned should yields retrace some of the gains.

Portfolio positioning
There are a number of risks on the horizon. The rand has been sluggish, despite the record inflows into our market and may well be reflecting some of the local risks. Slowing growth could put further pressure on the national budget and an already widening current account deficit. This is not sustainable in the long run. Political uncertainty around nationalisation and the direction of economic policy is also weighing heavily on the outlook. It was thus not surprising that rating agency Moody's decided to downgrade the country's credit rating. Another concern is that we remain on negative watch with all three major rating agencies. Bonds could weaken from here as investors demand a higher premium to hold South African bonds in this environment. Some of this higher premium can already be seen in the steepness of the yield curve. Investors are demanding a substantially higher yield to lend money to the government for more than 10 years. The rand is likely to continue its weakening bias in this environment. A weaker rand would feed through into higher inflation, making the SARB's job more difficult against a backdrop of subdued growth. We continue to prefer corporate debt as it offers a superior yield as well as being shorter in maturity. We have concentrated the underweight duration position in the long end of the curve as we believe this area is most vulnerable to a sell-off.

Market review
The second quarter of 2012 was very volatile as the world continued to worry about the woes of Europe and faltering global economic growth. The bond market shrugged of these concerns and returned a very impressive 5.2%, helped by improving inflation and record foreign inflows. Cash, as measured by the STeFI Index, delivered 1.4% for the quarter. With the sharp pullback in the oil price and a decent moderation in food prices, we have seen consumer inflation drop back inside the official target band. This is broadly in line with our forecast that rates will remain on hold well into next year. Due to the sharp slowdown in global growth, the risk is now that the South African Reserve Bank will cut the repo rate later this year. Bonds were further buoyed after foreigners bought R21.3 billion worth of bonds in June, a new monthly record. These flows were driven in part by the confirmation that South Africa would form part of the Citibank World Government Bond Index in October. The market received a further lift, thanks to the belief that European leaders will finally show some leadership and implement concrete steps to help solve the banking and debt crisis in that region. The rand also benefited from these flows and we saw the local currency closing below R8.20 against the US dollar. The euro region remains the biggest concern going forward as growth has stalled and political uncertainty could easily trigger another bout of asset selling. It is thus important to keep abreast of euro-zone developments. China is also showing signs of slowing down, which adds to the probability of another soggy growth patch. On the local front, the economic data was more mixed. Good inflation numbers were offset by a higher than expected current account deficit.

Portfolio review
The Investec Gilt Fund had a good quarter, benefiting from a very strong bond market. This has been a prolonged rally in yields, driven predominately by the huge foreign inflows. Global central banks have pumped billions of dollars and euros into the system in order to try and stimulate growth. The biggest beneficiary of this money has been the financial markets and emerging markets in particular. Global investors are searching for yield as cash rates in the developed world remain at or near zero. This makes countries like South Africa, Brazil and Mexico look attractive. Our bonds and currencies have thus rallied hard on these flows. Risks do remain though and we have reduced some of the duration in the portfolio accordingly.

Portfolio positioning
The current account deficit will weigh heavily on the rand and make the local currency vulnerable to foreign sentiment. Growth and unemployment continue to disappoint and at the next few meetings the monetary policy committee will consider the next course of action for interest rates. The market is currently pricing in around a 30% to 40% probability of a cut before the end of the year. Interest rates are likely to remain low well into 2013, as we see inflation continuing to ease. Bonds have performed very well over the past year with a return of just under 15%. This is well in excess of bond yields and nearly three times more than the return from cash. In our view, this is not sustainable. We continue to take profits in order to protect some of this capital gain, by reducing the duration in our portfolios. Bonds are likely to be range bound for the remainder of the year, but we are nearing the lower band. Corporate bonds still offer good yields and we have continued to build up the exposure to these bonds in the portfolio. Inflation has now peaked and will move down to around 5%, which makes inflation-linked bonds less attractive. We sold out of these instruments and replaced them with nominal bonds.

Market review
The bond market started the year on a strong note as yields rallied across emerging markets. Economic data indicated that global growth was starting to show signs of a sustained recovery. This saw risk assets performing well as investors started searching for yield. The rand appreciated as foreign inflows into South Africa increased. The European crisis, while not yet averted, diminished slightly as Greece finally settled on a deal to reduce its debt levels. This gave bond investors further encouragement to invest in emerging markets again. Sentiment was further helped by the European Central Bank's assistance to European banks by lending them money through the long-term refinancing operation (LTRO) programme, aimed at increasing liquidity and encouraging the buying of government debt. This led to aggressive rallies in yields across the 'troubled' European bond markets like Italy and Spain. The momentum added to the goodwill towards emerging markets.

On the local front, the All Bond and Listed Property indices returned 2.4% and 8% respectively over the quarter. The rand gained more than 5% against the US dollar, reflecting the broader rotation into riskier assets. Cash, as measured by the STeFI, returned 1.4% over the review period. The minister of finance delivered a much improved budget, demonstrating his commitment to tight fiscal management. The South African Reserve Bank (SARB) remains concerned with the twin dilemmas of rising inflation and sluggish growth. While inflation is nearing its peak, it is still outside the target band and a stubbornly high oil price is ensuring that inflation remains elevated. Some good news was the announcement by Eskom that this year's price increase will be reduced from 26% to 16%. While we are seeing small gains in the employment numbers, these are still below the required level. Growth in the economy is showing signs of improving, but is still lagging levels seen before the global credit crisis and we will be lucky to achieve growth of 3% over 2012. This is keeping cash rates at multi-decade lows, translating into negative real returns for investors. The situation is likely to continue for the rest of the year as the SARB aims to keep rates on hold for as long as possible.

Portfolio review
The Investec Gilt Fund had a good quarter, helped by the strong bond market rally in January. After this rally, we reduced the portfolio's duration by selling some long-dated paper.
Portfolio positioning
Despite a very good national budget, bonds have been a bit 'soggy' since February as investors grapple with global risks. Government finances in Europe (and in the US) are still precarious and as a result, yield curves remain steep. We have diversified the risk by increasing the portfolio's exposure to good quality corporate bonds. The focus is on enhancing the yield in this low yield environment. Should yields rise from current levels, we will look to add some duration to the portfolio.

Market review

Looking back, 2011 was a tumultuous year with excessive volatility and where uncertainty became the norm. Markets reacted to news headlines and not the details of reports and were often disappointed. This led to crazy price action that frequently unwound when the dust had settled. Our markets were dominated by global events, most notably the unfolding European crisis. Expectations that EU politicians would tackle the region's problems decisively, boosted market sentiment, but the lack of any meaningful progress soon led to disappointment.

The final quarter turned out to be quite strong for the bond market. The All Bond Index returned a very respectable 3.5% as yields rallied slightly into year-end. Cash, as measured by the STeFI Index, returned 1.4%. Listed property closed up 3.7%.

Portfolio review

The Investec Gilt Fund performed in line with the All Bond Index as we had reduced the underweight duration position. We are still positive on SA corporates and have maintained our exposure accordingly. We have added some inflation-linked bonds to the portfolio.

Portfolio positioning

South Africa's macro drivers, while largely ignored for now, are starting to pose a challenge to the South African Reserve Bank (SARB). Inflation has broken out of the upper band of the inflation target, but growth on the other hand is very subdued and has in fact disappointed this past year. Both these dynamics will continue into the next few quarters and should make for interesting discussions around monetary policy. With the continuing EU crisis, global slowdown (and even recession in some regions), and the resulting effect these will have on our exports, the SARB will be keen to stimulate the local consumer with a rate cut. Stubborn inflation and an extremely volatile Rand will make this action very difficult.

While all fixed income managers will be closely watching the actions (and inactions) of the European Central Bank around debt purchases, local drivers will also be carefully monitored. We are only 2 months away from the budget speech and due to the softer economy we can expect some more bad news in the Finance Minister's speech. Revenue is likely to be revised downwards while expenses remain stubbornly high, all leading to a fine balancing act. It is very likely that we could see an increase in government funding for 2012. Some of this is priced into the market. Bond yields have not moved much over the year when comparing starting and ending yields. This belies the fact that the R207 (10-year bond), which finished 2011 at around 8%, the same level that it started the year, did in fact trade as high as 8.8% in March and moved down to 7.4% in September.

The longer-dated bonds have underperformed as the yield curve has steepened. This has happened in almost all bond markets around the globe as government's battle to raise sufficient revenues to meet their commitments. The situation is likely to prevail as we head into 2012. A huge driver of yields was also the foreign flows, which will continue to increase volatility in our market.