The third quarter was a volatile period for bond yields. The R153 reached all time lows in August on the back of a stronger Rand and expectations of further interest rate cuts before selling- off aggressively to end the quarter on a weaker note. The sell-off was driven by rising US yields and an unwind of expectations for further interest rate cuts as inflationary fears were sparked on the back of higher oil prices. The market chose to ignore the compression seen in emerging market spreads and the strength in the trade-weighted Rand. The cash curve steepened further, with 12-month NCD's rising 0.30% to end the quarter yielding 7.30%.

We continued to see supply dynamics and the large revenue overruns as bond supportive but this was offset by our cautious view on inflation, which we see moving up towards the top end of the target range in the first quarter of 2006 largely as the result of sustained higher oil prices. We also keep our cautious bias on global markets, where we are relatively positive on growth and wary of inflation. We therefore stayed defensive on the bond exposure in the portfolio. Similarly, on the money market portion of the portfolio, we remained underweight, investing in the shorter to medium end of the cash curve.

Our cautious stance on the bond market and longer dated money market instruments helped mitigate the effects of the rise in longer-dated cash and bond yields.

We expect domestic growth to be relatively robust this year, but continued higher oil prices have led us to become more cautious on inflation going forward. Although we expect that the SARB will to some extent look through the rise in inflation from higher oil prices, we believe that there will be some upward pressure on interest rates in the first half of next year. We also still remain cautious about the size of the current account deficit, despite it being easily financed at present, and continue
to see this posing a risk in the future. We also maintain our call for global yields to rise modestly towards the end of the year, and exert upward pressure on domestic yields.

Although the domestic bond market continues to trade very close to fair value at current levels, we see the fair value yield continuing to rise gradually from here in the coming months. With longer dated money market yields likely to follow bond yields higher, we continue to see the best value largely in the shorter end of the cash market. As a result we will broadly maintain our current positioning, with short cash duration and limited exposure to the bond market.

After the sharp back up in yields in March, the bond market rallied in the second quarter of the year. Again, the favourable domestic environment with benign inflation remained the key factor supporting the bond market, while a surprise 50 basis point cut in interest rates in April gave the rally an extra boost. This favourable backdrop was given added impetus by the change in mood in international markets, as concerns of a slowdown in global growth saw international bonds yields fall. This in turn gave rise to an increase in global risk appetite as the search for yield resumed and South African bonds experienced huge demand from offshore investors. The benchmark RSA R153 yield which started the quarter at 8.20% traded down 63 basis points to end June at 7.57%. The shape of the yield curve was largely unchanged with yields moving down in a parallel fashion, except for the very long end, which only managed to rally 30 basis points versus the 60 basis points seen on the yield curve as a whole.

While we remained largely positive on domestic fundamentals throughout the quarter, we also kept our cautious bias on global markets. We maintained our defensive position on our bond portfolios, with duration fluctuating between neutral and underweight throughout the quarter.

With our cautious stance on the bond market, our bond portfolio duration moved between being almost neutral and short duration throughout the quarter, as we actively managed risk and the trading range. This meant that we outperformed the index over the quarter.

Other than the crucial duration decision, bullet-barbell and slope strategies have added to performance. In particular, bullet-barbell strategies that took advantage of the humpedness of the curve added extra performance to the portfolio, as has continued active trading. We expect domestic growth to be robust this year, but with inflation remaining well contained and official interest rates remaining on hold. We still remain cautious about the size of the current account deficit, despite it being easily financed at present, and continue to see this posing a risk to interest rates in the future. With our forecasts for global yields to rise modestly towards the end of the year, we expect to see some upward pressure on domestic yields.

Although the market is very close to fair value at current levels, we see the fair value yield rising gradually from here in the coming months. As a result we are maintaining an underweight duration position in our bond portfolios, but will look to trade the range.

April was dominated by the surprise rate cut by the Monetary Policy Committee (MPC). Bond yields had remained at the higher yields achieved during the March sell-off, but quickly reversed when the SA Reserve Bank announced the rate cut. This led to bonds making back some of the negative returns from the previous month. The benchmark RSA R153 rallied strongly to close the month at 7.85%. The Reserve Bank indicated that they were concerned with the slight downturn in economic activity as well as the continued strength of the Rand. Furthermore, the softer economic data globally led to underlying support for all fixed income markets.

The Rand will continue to be a dominant factor as market participants start to anticipate the next move by the MPC. In light of their latest statement, one must assume that they will be inclined to cut further if the Rand continues to strengthen. Our central case is for rates to be on hold for the near future as the market comes to terms with the effect of the Barclays/Absa deal.

Inflation should continue to rise moderately over the next two months as the effect of higher oil prices feed into the economy. The current account remains an increasing source of concern and is expected to ultimately result in some modest depreciation of the Rand in the longer term.

The global environment is now more mixed with expectations of fewer rate hikes as the global economy shows some signs of slowing.

Your fund remains defensively positioned as breakevens to cash do not look compelling. However we will look to modestly increase duration as yields move higher.

March saw a big sell off in the local bond market and a significant steepening of the yield curve. The move was driven by international developments, as the US Federal Reserve signalled a change in stance going forward, with an increased focus on inflation. US treasuries and emerging market debt sold off sharply, with the Rand and domestic bond markets also falling victim to the shift in global sentiment.

The back up in bond yields saw the benchmark RSA R153 yield trade up some 80 basis points to close the month at 8.20%. This was despite the release of very good February CPIX data, which at 3.1% was only just above the bottom of the 3-6% target band, and large revenue overruns which will further reduce funding pressure in the bond market.

Despite the fact that we saw a sharp correction in March from February's historic lows, we remain cautious on the market and are maintaining our underweight duration position on the portfolio.

Although we expect inflation to remain well behaved, we believe that we have seen the low in CPIX and that it will start to move back towards the middle of the target band and that the Reserve Bank will keep interest rates on hold through this year. The current account remains an increasing source of concern and is expected to ultimately result in some modest depreciation of the Rand. In the global environment, we expect US rates to continue to rise and the premium demanded for risk assets to widen, exerting further pressure on the local market. As a result we expect that bond market yields will continue to rise modestly into the latter part of 2005.

December saw a continuation of the recent bond market rally, with the benchmark RSA R153 trading to yet another all time low in yield at 7.73% before correcting marginally into year-end. This was despite the second consecutive higher than expected inflation number after the spate of very good numbers that started earlier in the year and a rapidly deteriorating trade balance. The market again shrugged off any negative news on the view that inflation will remain comfortably within the Reserve Bank's target range for the next 12 months. The strong Rand also lent support to the bond market as it continued to firm against the weak US Dollar, and the international search for yield and diversification away from the US Dollar continued unabated. The yield curve flattened through the month, with the long end of the curve again outperforming the short and medium dated bonds.

Although we continue to expect inflation to be benign and interest rates to be on hold for the next year, the good news is definitely all priced in now, with little room should any of the numerous market risks materialise. The current account remains a source of concern and is expected to ultimately result in some modest depreciation of the Rand, despite the immediate outlook for the Rand remaining favourable. The global environment is more uncertain, but we still expect US rates to rise and exert some pressure on the local market. As these risks balance against the positive domestic backdrop, we expect that bond market yields will rise from current levels in the New Year.