Market review
The weakness in the bond market witnessed in the first quarter continued into the second quarter, with the bond market returning a negative 4.9%. This was sparked by comments from South African Reserve Bank governor, Tito Mboweni, signalling that more drastic action was needed to combat inflation which had become more generalised. The 1-3 year area of the curve outperformed, returning a negative 1.3%, still well behind cash, which gave a return of 2.7%. International energy prices surged, stoking inflation fears globally.

Fund performance
The Investec High Income Fund Namibia returned 1.3% over the second quarter, outperforming its benchmark, the BEASSA 1-3 year All Bond Index by 2.6 percent.

We maintained the defensive position adopted in the first quarter and where possible we reduced exposure to credit in South Africa. The Namibian bond exposure was kept largely neutral because of the scarcity factor and lack of liquidity. The Namibian spreads above the South African bond curve were unchanged over the quarter, with the Namibian yield curve moves taking their lead from developments in South Africa.

The fund's positioning over the quarter meant that it outperformed its benchmark in each of the three months. In May, bonds performed particularly poorly and our aggressive underweight position during this period, added substantially to performance. The strategy on the cash portion of the fund has been to increase yield by investing in floating rate notes linked to JIBAR to take advantage of higher rates in South Africa. To a limited extent we have also been able to do this in the Namibian cash market.

Portfolio activity
The exposure to South African bonds was increased in June after the May sell-off, but we remain substantially underweight duration. Exposure to the Namibian market was relatively unchanged.

The fund's exposure to the Telecom Namibia bond due in 2015 was increased to 0.85%. We continued to selectively buy highly rated, well priced securitisations and selected short-dated single name credit linked notes, reducing exposure where possible to some older, more tightly priced issues.

The widening swap spreads look very attractive as an alternative to short-dated government bonds with much higher yielding highly rated bank notes.

Market outlook and portfolio positioning
Inflation has continued to surprise on the upside. Producer price inflation figures for May printed well above expectations, further stoking inflation fears. The market is now expecting another 0.5%increase in the repurchase rate in August, with inflation set to peak between 12% and 13% in the third quarter. The uncertainty around the implementation of electricity tariff increases at municipal level could however result in a lower but flatter peak in the inflation profile.

Anecdotal evidence suggests that consumers and businesses are struggling to cope with high interest rates. If official data starts to point to a more dramatic slowing of the economy this could persuade the South African Reserve Bank not to hike rates in August.

The portfolio still has a large short duration position relative to the benchmark and we will be looking for some buying opportunities in the near future.

We expect the scarcity factor of Namibian government bonds to keep spreads from widening while the South African bond market remains
under pressure, but to resume the tightening seen in recent years once the environment becomes more bond friendly.

The biggest risk to our portfolio is that the bond market continues to ignore the high inflation figures and starts to aggressively price in rate cuts by the end of 2008, as domestic growth slows sharply.

We expect the bond market to be volatile and believe that there will be better buying opportunities in the months ahead. Inflation is going to remain a problem in the coming months.