Market review
The rescue of Bear Sterns in March proved to be a watershed event that brought an end to the collapse in credit markets. Credit spreads stabilised and rallied somewhat over the second quarter. Government bonds sold off, as the flight to quality bid that they had enjoyed began to reverse. Rising oil prices and disappointing inflation data shifted the attention of central banks towards limiting inflation expectations, with the European Central Bank (ECB) signalling that it would raise interest rates.

Emerging market bond yields rose sharply in response to worse than expected inflation data and a more aggressive policy response. The poor performance of local bond markets was offset by a generally favourable move in emerging market exchange rates. The Investec Global Opportunity income Fund of Funds held a moderate position in these markets.

Fund performance
The Investec Global Opportunity Income Fund of Funds returned -4.2% in rand terms over the second quarter, outperforming its benchmark. For the year to the end of June the fund returned 21.5% in rand terms.

The performance over the quarter benefited particularly from a short duration position. Yields rose sharply as credit fears waned and the focus of the market shifted to rising oil prices and the associated pick-up in inflation. Other drivers of returns were mixed.

Portfolio activity
The fund's exposure to corporate bonds, particularly investment grade financial paper, was increased significantly during the second quarter to benefit from the exceptional value created by the credit crunch. The portfolio had a short duration position during the quarter which was reduced as yields rose. A long position in European interest rate futures was added as the market overreacted to the shift in ECB policy. A short position was also opened in Canadian bonds, which had become expensive.

In currency markets the ECB's move to tighter monetary policy came as a surprise. We had expected the US dollar to find support as the US economy started to stabilise. However, the change in interest rate expectations outweighed this. Other currency positions were limited. The yen was weak versus other major currencies over the period as credit concerns eased.

Market outlook and portfolio positioning
Global economic activity is being threatened by rising inflation and seems likely to continue to slow in the second half of the year. Oil importing nations are likely to bear the brunt of the adjustment. Japan and the UK are already close to recession (a period of zero or negative economic growth). Europe looks set to slow sharply and the US economy is expected to limp along. Inflationary pressures should ultimately ease, but the trade-off between growth and inflation appears to have worsened. This will make it harder for central bankers to meet their inflation targets over the medium term without resorting to interest rate hikes.

Major bond markets are priced for weak economic data. Once growth fears begin to wane, government bonds are likely to resume their sell-off. We currently have a very small negative duration position, which we will look to increase into any strength. European bonds offer the best value and we are rebuilding an overweight position. Inflation in Europe is lower than in the US and monetary conditions are tighter. We expect yields in these two markets to converge in Europe's favour.

The euro is vulnerable to signs of a slowdown in Europe and we hold moderate long US dollar exposure against it. We also like the Canadian dollar on valuation grounds as Canada is a major oil exporter. We have a small short position in sterling, despite its relative weakness. We are also negative towards the Swiss franc and the Australian dollar.

Emerging market bond yields appear to have priced in the bad news on inflation and we expect these markets to offer decent returns in the future. We continue to prefer markets in Asia and Latin America, where the balance of payments fundamentals are strongest. Investment grade bonds remain cheap and better quality high yield bonds are beginning to offer reasonable value again. We will use the current nervousness to add to exposure.

Market review
US economic data continue to point towards recessionary levels. Some key data releases remain more consistent with a softer landing, but the economy is rapidly losing momentum. Policymakers have been aggressive in looking to limit the downside risks. Data elsewhere have held up better than expected, thanks in part to the continued resilience of emerging economies and the partial offset that this is providing to sagging US growth.

Fixed-income markets have been dominated by the de-leveraging of credit-starved institutions. This has led to forced selling of nongovernment bonds, which has overwhelmed the normal functioning of markets. In turn, this has exacerbated mark-to-market losses and further undermined risk appetite. Credit spreads have ballooned, especially for financial names. The US Federal Reserve has been working to short-circuit this vicious circle and have signalled that it is prepared to do whatever is necessary to avoid a financial meltdown, even if this requires unorthodox methods.

Fund performance The Investec Global Opportunity Income Fund of Funds returned 26.1% over the first quarter, while the benchmark gained 25.4% (in rand terms). For the year to the end of March the fund returned 25%, while the benchmark increased by 27.9% in rands. The fund was ranked first in its sector over the quarter and second for the year to March.

The first quarter of 2008 was characterised by continued credit market dislocation and flight-to-quality buying of US Treasuries. Government bond yields fell sharply, helped by signs of much weaker global growth, with the short end of the US market leading yields lower. We were too defensively positioned in terms of duration, especially towards US bonds, but correctly anticipated that longerdated maturities would underperform. The fund was well positioned to benefit from dollar weakness, particularly against the yen, which was helped by investor nervousness. Credit markets remained under pressure from the ongoing liquidity squeeze. Although the fund was defensively positioned, the market continued to penalise any nongovernment exposure.

Portfolio activity
Against the current market backdrop, we have gradually been adding credit exposure at what appears to be extraordinarily cheap levels, even when the worsening economic environment is considered. We tended to be moderately short US Treasuries and increased this position as the market traded at extremely low real yields thanks to market panic. We reduced our exposure to curve steepeners during the quarter for similar reasons. Emerging market holdings have been focused on countries with positive interest rate environments such as Turkey and Israel.

Currency markets remained volatile. The US dollar weakened during the quarter against both the euro and the yen, as did the major commodity currencies. Currency exposure tended to favour the yen and, to a lesser degree, European currencies, except sterling. Short dollar exposure was gradually reduced as the dollar weakened to extended levels.

Market outlook and portfolio positioning
Thanks to the action taken by the US Federal Reserve and others, the credit crunch is now entering a new stage. Uncertainty will remain high, but the dominant driver of markets should begin to shift away from liquidity-driven panic towards a greater focus on the underlying fundamentals. These are undoubtedly poor, with corporate profits under severe pressure, but in many cases bond valuations have moved beyond pricing in a weak global economy to pricing in economic catastrophe.

We see increasingly great value in high-grade credit, especially senior bank debt, and expect to build a reasonable exposure in the next few months. The yield premiums over government paper offered by these bonds are at multi-year highs, well above what was available in the two previous recessions. Better quality high-yield bonds are also becoming attractive. Even as credit quality worsens, investors are being overcompensated for likely defaults, especially on a welldiversified basis.

US Treasuries remain expensive and have begun to lose their flightto- quality bid. As we approach the likely trough in the federal funds rate, at least for this year, we expect yields to sell off as they tend to do at this point in the cycle. The good news, and more, is in the price. We will retain a core short duration position in US government bonds, adding on rallies.

Other developed government bond markets look less overbought and should outperform, but offer limited potential on an outright basis. We do see some opportunities in short-dated European and Swiss bonds, which price in very little possibility of monetary easing despite tightening monetary conditions via appreciating exchange rates.

We have mixed views on emerging market debt. The risks for the asset class as a whole have risen, especially for countries with weak balance of payments positions, but there are still opportunities on a more selective basis, which we will look to exploit. The dollar may remain weak for a little while longer, but it is beginning to look very cheap, with much of the negative news priced in. We have taken profits on our short dollar position and have reduced risk, waiting for new trends to establish themselves.

Market review
Global economic data weakened during the quarter, but remained consistent with a soft landing rather than a recession, even in the United States. More significant, however, were renewed signs of stress in the money markets and significant write-downs within the financial sector, which reinforced market fears about the potentially very negative economic consequences of the credit crunch. Against this backdrop, both the US Federal Reserve and the Bank of England cut interest rates to offset slower growth and, together with three other major central banks, they eventually engaged in apparently successful coordinated action to ease the strains in the money markets.

Market reactions to these events were violent. US treasuries rallied sharply, yield curves steepened and credit and swap spreads widened, especially at short maturities. Despite cautious comments from the US Federal Reserve, the short end of the treasury market moved quickly to price in aggressive rate cuts of approximately 2.5 percentage points from their pre-August peak.

Fund performance
Performance was disappointing during the final three months of the year, and especially in November. During that month, US short-dated bonds rallied by about one percentage point and correlations with all forms of US interest rate related exposure rose sharply. We had put on a range of positions post the August sell-off at what appeared to be very attractive levels. The violence of the moves in November, however, drove many of these trades to multi-year valuation extremes, resulting in underperformance. Soft economic data certainly helped to push yields lower. However, the demand for short-dated US bonds was exacerbated by the hedging of illiquid positions related to the sub-prime mess. This hurt exposure to curveflattening positions and short-dated swap spreads. Cross-country exposure also detracted from performance, especially a short position in US treasuries versus European government bonds.

The Investec Global Opportunity Income Fund of Funds returned -0.7% in rands over the quarter, while the benchmark delivered 3.4% in rands. For the year to December the fund returned 3.4% in rands, while the benchmark delivered 7.4% in rands.

Portfolio activity
Going into the quarter, we did not have a large duration position, but began to build a reasonable short exposure during November, as the market appeared to move too far ahead of likely official policy action. We also built up curve flattening positions, given the relative expensiveness of short-dated bonds and retained exposure to swap spreads, also on valuation grounds. In a number of cases, these positions had reached multi-year levels of cheapness. However, this was not enough for them to work in the short term, especially as investor fears and hedging activity kept the treasury market well bid. US bonds also significantly outperformed European bonds, despite signs of a sharp slowdown in European Union (EU) growth. As a result we decided to cut exposure to this cross-country position and await a better entry level to reinstate it.

Currency markets were also volatile, but fairly directionless. The US dollar weakened initially during the quarter against both the euro and the yen, but then recovered. Currency exposure tended to favour European currencies against the other majors. Volatility, however, made it difficult to hold positions with much conviction.

Credit exposure remained light. Emerging market holdings focussed on countries with positive interest rate environments such as Turkey and Israel.

Market outlook and portfolio positioning
As a result of the price action of recent months, a number of exciting investment opportunities now exist in the bond market. In particular, US bonds look increasingly expensive. Ten-year treasury yields adjusted for core inflation are close to multi-year lows. Two-year treasuries are trading at their most extreme yield discount to the federal funds rate for at least 20 years. To rally further, the US Federal Reserve will need to start cutting rates aggressively and ultimately by at least another 150 basis points for two-year US bonds to look fairly valued. A recession could achieve this, but one is not yet certain to occur. Without a recession, two-year bond prices will fall substantially this year. Ten-year treasuries may not be able to rally much more even with a recession, especially as inflation looks much more problematic than in the last business cycle. We are looking to build a significant short position in ten-year bonds and partially hedge the recession risk with a curve steepening position. Japanese bonds are also expensive, with rate increases no longer priced in. There is better value in other markets, especially Europe, and we will build exposure here as the outlook for the global economy becomes clearer. We also like index-linked bonds on a relative basis in an environment of rising food and energy prices.

Yield spreads offered by high-quality shorter-dated non-government paper remain relatively cheap and should offer decent returns. We also remain comfortable with moderate exposure to a range of emerging market bond and currency markets where we see favourable cyclical dynamics.

We expect the dollar to weaken further in the near term, but ultimately to recover, especially against European currencies once all the bad news is in the price. In the short term, the yen offers a hedge against a further deterioration in investor risk appetite and we have built a moderate position against the dollar and the euro, as well as holding small positions in a range of other currencies.