Market review
Bond markets experienced extreme price swings during the third quarter. The traditional safe haven assets performed well: both US Treasury yields and German Bunds fell to record lows, closing the quarter at 1.9%. Spreads on investment-grade corporate bonds widened sharply, especially in the case of high yield. As a result of weakness in emerging market currencies in September, returns from emerging market debt were negative over the quarter. The return on the Citigroup World Government Bond Index was 2.4% in US dollar terms.

Portfolio review
The third quarter witnessed a collapse in investor risk appetite, similar to that experienced at the height of the credit crisis in 2008. This negatively impacted the performance of the portfolio, particularly through the very sharp sell-off in corporate bonds. Interest rate positioning and emerging currency exposure were also negatively affected by dramatic market moves. Credit and currency hedges held by the portfolio helped to reduce the impact on performance. The Investec Global Opportunity Income Fund of Funds delivered a return of 11.7% in rand terms over the quarter. Rand weakness over the review period boosted the return.

Portfolio activity
It was the second worst quarter on record for local currency emerging market bonds, according to JP Morgan. The review period was the third worst quarter on record for credit spreads, according to Merrill Lynch, and the third biggest quarterly rally in government bonds in the last decade, also according to JP Morgan.

Selling pressure cascaded through markets. Credit markets start to fall first in late July; the euro was next, collapsing from late August. Emerging currencies then followed with a brief lag, and from mid-September it was the turn of emerging market local currency bonds. This sequencing of events suggests that there was a gradual capitulation in long positions across markets, as investor risk appetite was undermined by the weakening growth outlook and euro-area fears.

In retrospect, our strategic asset allocation process led us to be too positive towards credit and emerging market currencies going into the quarter. This positioning was based primarily on valuations, but supported by low interest rates and an expectation that global growth would recover somewhat in the second half of the year. We anticipated that global growth would improve as supply disruptions caused by the tsunami dissipated and the squeeze on consumption from higher petrol prices eased.

As sentiment began to worsen, we took action to reduce risk. We hedged a portion of the corporate bond exposure in the portfolio, reduced the allocation to emerging currencies and favoured US dollars above growth-sensitive commodity currencies. Furthermore, we increased developed government duration to flat. These actions benefited the portfolio.

Portfolio positioning
The collapse in risk appetite during the third quarter was more severe than the deterioration in economic data alone would have suggested. Markets appear to have moved rapidly to price in a very high probability of recession and/or a fat tail event (a rare and extreme occurrence) in Europe. Our central case is that a recession will be avoided, with leading indicators suggesting a low probability of one occurring. We also expect Europe to support its banking sector and provide funding for Italy and Spain in the likely event that Greece is forced into a more substantial restructuring of its debt.

In the short term, there is scope for further capitulation by investors, but unless the market's worst fears are realised, there is significant potential for risk appetite to recover in the medium term. Tactically, we have reduced risk exposure, and are managing it actively, with a view to increasing it again into any further weakness. Core government bonds appear fully priced for recession. Real yields in the major western markets are now negative for bonds with maturities shorter than ten years. Our fair value measures suggest that yields on medium- to longer-dated bonds should rise by about 50 to 100 basis points, if the global economy avoids a sharper downturn. The US is our least favoured market. We prefer the higher-yielding markets of Australia and Norway, but expect to cut duration again into market strength. Corporate bonds offer the prospect of decent excess returns over time. High Yield, for example, is priced to withstand a 14% annual default rate, much higher than the worst-ever realised annualised default rate seen during the Great Depression. We intend to lift the hedges on the corporate holdings of the portfolio when the outlook clears, to take advantage of the excellent value now available.

Developing government bonds are also reasonably attractive. Yields are trading at wider than average levels against developed markets, and central banks are switching from tightening towards easing. The bigger opportunity, however, looks to be in emerging currencies. Position-cutting has taken them about three quarters of the way to being as undervalued as in prior crisis periods. While emerging currencies could weaken further, fundamental support looks better now than in the past. We have hedged some of the possible downside risk by selling relatively more expensive pro-cyclical currencies such as the Australian dollar. The US dollar has been the main beneficiary of position-squaring and may continue to make further gains in the near term, especially while euro-area stresses remain acute. Again, we view these hedges as tactical and intend to lift them when conditions stabilise.

Market review
Global economic data softened during the second quarter, partly due to supply disruptions in Japan after the tsunami. Government bond yields generally rallied as a result, in both developed and emerging markets. Corporate bonds underperformed with yield spreads rising quite sharply as investor risk appetite deteriorated. In currency markets, the US dollar sold off initially, but recovered most of its losses as concerns grew about peripheral markets. The Swiss franc was the major beneficiary of safe haven flows, taking the currency to historically very expensive levels.

Portfolio review
During the quarter, exposure to emerging bond markets added to returns as yields rallied. Other elements hurt performance. We were too negatively positioned early in the quarter in terms of duration, with yields falling on growth and Greek funding concerns. This also caused credit spreads to widen, hitting returns from corporate bonds. Currency markets were characterised by a general 'risk-off' bias.

Portfolio activity
During the quarter, duration was increased as yields began to rally in response to weak data, with the portfolio moving to a flat position overall. Duration exposure was then cut again as yields fell to relatively expensive levels. Profits were taken on US five-year treasury inflation protected securities (TIPS) which had benefited from the sharp run-up in oil prices. Exposure to corporate bonds and emerging market debt was broadly unchanged through the quarter. Within corporate bonds, holdings in bank issues were reduced in favour of bonds from non-cyclical industrial issuers. During the review period, exposure to the US dollar was reduced as the currency recovered. Exposure was raised to the euro and the yen, although exposure to major currencies remains underweight versus the benchmark in favour of higher yielding developed and developing currencies with better potential.

Portfolio positioning
Fears about weak economic data and Greek financing needs look set to ease, allowing risk appetite to recover over the next few months. Global economic activity is also expected to rebound. Meanwhile, new fiscal measures have opened the way for additional loans to be made to Greece, avoiding a near-term default event. Against this backdrop, we expect developed government bond yields to rise, but see value in corporate bonds on a relative basis and expect yield spreads to narrow. We continue to prefer inflation-linked bonds to conventional government bonds, especially in the UK, given sticky retail price inflation. We also expect emerging market government bonds to outperform their developed market equivalents, thanks to some easing in inflation concerns and signs that policy tightening is close to completion in a number of markets. Renewed risk appetite should put some downward pressure on the US dollar and the yen, helping the euro to revisit the top of its range, and procyclical developed and emerging currencies to outperform.

Unfortunately, there is, as yet, no comprehensive solution to Europe's funding problems, just an ongoing attempt to buy time. As a consequence, political noise and default fears seem likely to resurface again either later this year or some time in 2012. There are also potential shorter-term risks stemming from a failure by Congress to raise the US debt ceiling in a timely manner. If the US Treasury is forced to default on payments next month, we believe a systemic financial crisis is a real possibility, given the amount of market exposure which is backed by Treasury collateral. Such an outcome is still a very low probability event, but we are looking for low cost ways to hedge against it where possible. Finally, it is hard not to conclude that we are reaching the limits of global policy easing, and, as a result, the risks to growth in 2012 appear to be to the downside. So far, our asset allocation scores remain net positive for risk assets, such as corporate bonds, and the path of least resistance is for this oversold market to bounce in the near term. However, it seems prudent to adopt a tactical approach to risk management going forward, managing exposure in a contrarian manner as the market swings between hope and fear.

Market review
Global economic data strengthened as we moved into 2011, with a recovery in manufacturing and a broadening of demand pushing growth higher. Oil prices rose above $100 per barrel, with political turmoil in a number of Arab countries adding to the upward pressure. This boosted headline inflation and inflation expectations. In response, a number of emerging central banks raised interest rates and the European Central Bank adopted a bias to tighten. By contrast, the US Federal Reserve continued its policy of quantitative easing. The Bank of Japan also loosened policy further, after the tsunami destroyed a number of coastal towns in northern Japan and disrupted power supplies and transportation. The G7 joined the Japanese in intervening to stop yen appreciation on asset repatriation, following the disaster.

Portfolio review
Interest rate positioning and corporate bond exposure boosted returns over the first quarter, but currency positioning detracted from performance. The portfolio benefited from being long inflation-linked bonds and being short duration overall, but was hurt by having too defensive a position in the euro, which surprised with its strength over the period.

Portfolio activity
During the quarter, we became concerned that markets appeared relatively complacent about a variety of risks that could cause a sharp sell-off in risk assets, such as rising oil prices, geopolitical tensions and funding pressures in peripheral Europe. As a consequence, we hedged a portion of our exposure to credit markets, reduced positions in higher beta currencies, such as the Australian dollar, and added duration in government bond markets. When the correction came, however, it was relatively muted, with only a small temporary reversal in the rally in financial markets. In response, we decide to lift most of our hedges and revert to a more fully invested position in corporate bonds and emerging market bonds and currencies as well as cutting exposure to the US dollar and US Treasuries. Government bond markets were flat to weaker over the quarter. The portfolio was generally short duration across major developed markets, adding to short positions in the US on deteriorating inflation pressures and stronger growth. Some duration was added back in the UK as poor data appeared to weaken the case for a near-term rate hike, despite poor inflation numbers. Exposure was also added to inflation-linked bonds on worsening inflation dynamics. Corporate bond market exposure was increased late in the quarter after a brief sell-off. Emerging market debt exposure was held fairly constant, with yields relatively unchanged over the period. The portfolio also remained long emerging market currency exposure, which generally benefited from policy tightening in developing economies.

Portfolio positioning
The two key drivers of the rally in asset prices since 2009 remain in place: better than expected economic growth and very loose monetary policy. Despite significant doses of bad news from Japan, the Middle East and Portugal, markets continue to hold up surprisingly well, suggesting strong ongoing demand for risk assets.

In the medium term, this benign environment looks unsustainable, with cracks beginning to appear in the form of higher inflation and more hawkish central bank rhetoric. Leading indicators, however, suggest that growth should remain above trend for most of 2011 and any policy tightening is likely to be modest this year. Indeed, the response to Japan's earthquake and tsunami has been to ease monetary conditions further, with a massive liquidity injection by the Bank of Japan. Perhaps the strength of financial markets is, therefore, less surprising.

In combination, the still favourable economic backdrop, supportive valuations and positive market price behaviour, suggest that it is right to be overweight corporate bonds versus government bonds, and developing market currencies versus the majors. We have removed the tactical hedges we had in these areas for now and have once again embraced a more positive stance towards risk assets.

Within the corporate bond market we are overweight non-cyclical issuers in investment grade, given the lack of value we see in more cyclical names. We also have exposure to the better quality global banks, with some of this in higher yielding subordinated debt, which should benefit from new capital rules under Basel III. In high yield corporate bonds, new issuance has continued to provide opportunities to switch into good quality names with attractive spreads.

In emerging markets, we remain overweight a range of currencies which are attractively valued and where we believe official resistance to further appreciation against the US dollar is limited. We are more neutral on emerging market sovereign bonds, but see opportunities in some countries, where the risk of higher interest rates appears over-discounted.

We continue to see little value in conventional developed market government bonds, especially short-dated US Treasuries, which price in little prospect of policy tightening for the foreseeable future. With core inflation beginning to rise and unemployment now falling quite quickly, we expect markets to reassess the risk of higher rates before long, leading to higher yields and a flatter curve. Treasury Inflation-Protected Securities (TIPS) and other inflation-linked bonds offer better protection, given upward pressure on headline inflation rates. We expect the US dollar to remain weak until the US Federal Reserve signals a move towards tighter policy.

Market review
The advent of the US Federal Reserve's (Fed) second quantitative easing programme during the last quarter of 2010 was preceded by concerns about the slow recovery in labour markets, depressed house prices and a fall in core price inflation to near zero levels. The Bank of Japan followed suit, cutting short-term rates to near zero, while establishing a fund to acquire a wide range of assets, including government bonds. The European Central Bank maintained its official stance of low interest rates, while providing monetary and fiscal support to its weaker members, struggling under heavy debt burdens. Meanwhile, China adopted a somewhat more restrictive stance as investment spend and credit demand remained vigorous, and as evidence of inflation became increasingly visible over the second half of the year. Tighter monetary policy had by year end done little to subdue investment spend, industrial production or retail sales. While both equity and bond prices saw strong gains in the third quarter, bond yields surged in the fourth as the asset class faced a raft of headwinds. Economic data showed some improvement, bond auctions proved softer, investors switched out of bonds into equities and the Irish debt crisis evolved. In addition, widespread criticism of the Fed's continued use of unconventional policies, in the face of excessive government debt burdens, gained momentum. Global equities added 8.8% over the quarter, while global bonds lost 1.8% in US dollars, the latter cushioned by the surge in the Japanese yen.

Portfolio review
The portfolio had a decent quarter with corporate bonds and the short duration position adding significantly to returns, as markets priced in stronger economic data and higher inflation expectations. The latter also boosted the portfolio's holdings in inflation-linked bonds. The impact of currency exposure was mixed, with poor positioning in emerging currencies offsetting gains in the majors. Emerging bond exposure added modestly to returns.

Portfolio activity
Global economic data improved significantly during the fourth quarter surprising consensus expectations to the upside, with much of the world ending the year on a reasonably strong note. Despite this, the Fed went ahead with more quantitative easing, emphasising higher unemployment and lower inflation than is desirable. In addition, the US Congress enacted further fiscal easing. Government bonds sold off sharply led by the US, the portfolio's biggest short position. This was driven by worsening inflation expectations, which helped inflation-linked bonds to outperform. The portfolio took partial profits on the US short position during the quarter. Long positions were added in developed markets with better fiscal situations, namely Australia, Sweden and Norway, and there was a further allocation to short-dated emerging market debt. The portfolio went significantly shorter UK exposure, to capture the negative impact of poor inflation data and improving growth numbers on the bond market. Corporate bonds had a reasonable quarter, despite pressure on sovereign debt and subordinated bank bonds. The improving economic environment helped the corporate bond market. Concerns over peripheral Europe reached a peak in November with Ireland finally going to the EU for funds, including support for the Irish banking sector bailout. The portfolio continued to significantly reduce corporate bond holdings during the quarter. The biggest reductions over the quarter were in banking and utility exposure. The portfolio started the quarter defensively positioned towards the US dollar, which had been hurt by the apparent willingness of the US Federal Reserve to see the currency weaken as part of its quantitative easing programme. The fund took profits into weakness and gradually rebuilt dollar exposure at the expense of the euro, which subsequently suffered from peripheral EU funding concerns. Exposure to sterling was also increased on better data and a rising probability of a shift in monetary policy.

Portfolio positioning
A flurry of positive data surprises in recent months has led to significant upward revisions to 2011 growth expectations. This, and quantitative easing by the US Federal Reserve have fuelled a strong rally in financial markets.

Looking at the year ahead we expect the underlying environment to remain reasonably supportive, but see a number of challenges that are likely to prompt bouts of risk aversion and profit-taking in pro-cyclical assets and currencies. In particular, we believe that interest rate expectations may begin to price in a turn in the global interest rate cycle this year. Central bankers remain very cautious about tightening policy too quickly. However, rising commodity prices and outperformance by inflation-linked bonds suggest that investors increasingly believe that policymakers are behind the curve. Emerging markets should lead the way with developed markets increasingly priced to follow. In addition, European sovereign financing is likely to be an ongoing source of concern for markets. We expect markets to be volatile with sentiment swinging between optimism and pessimism and believe a somewhat contrarian approach to risk management should pay dividends. In terms of underlying trends, we expect government bond yields to rise further and we are short duration, especially in the US and UK. We prefer inflation-linked bonds as an inflation hedge, despite their recent outperformance, and continue to hold them. Corporate bonds are still attractive, but we have reduced our exposure given less compelling value. We are cautious towards duration in emerging bond markets, but see opportunities in countries where rates are unlikely to rise as much as prices suggest. The portfolio maintains a core holding in these markets. We continue to expect volatile range trading between the dollar and the euro. Currently, we see scope for the euro to lose more ground in the near term, given concerns about peripheral Europe and expectations of rising US interest rates. Emerging market currencies should outperform on better growth, pressure to tighten monetary policy and problems in developed markets. Valuations are not stretched, as central banks have kept their currencies at competitive levels through heavy intervention. We maintain a long position in a diversified mix of our preferred currencies.