The third quarter was much improved and the bond market registered positive returns. Interest rates were hiked again by the SA Reserve Bank (SARB) and we saw the Rand weaken. We remained underweight duration in your portfolio for the quarter. The market was however very volatile over this period. Your portfolio outperformed the index over the quarter by actively managing the duration during this volatile period.

The market has continued to trade in a volatile range which has allowed us to actively change the duration on your portfolio over the quarter. This has resulted in your portfolio out performing the index. The market has been driven by the following factors over the quarter: a) Inflation. The inflation rate has continued to rise over the quarter with CPIX rising to 5%. The big concern however is the degree to which producer price inflation (PPI) has risen and when this will be passed onto the consumer, which will then lead to the Reserve Bank needing to hike interest rates further. PPI inflation is currently over 9%.
b) Rand. The local currency has continued to live up to its reputation as the most volatile currency in the world as we saw the Rand/USD depreciate from around R7.20/$ to above R7.75/$ at quarter end. This currency weakness was driven by the concerns of our large current account deficit and our ability to attract funds to finance the deficit. This level of the Rand will make our exports more attractive while also curbing some of the excessive imports and thus lead to an improvement to our terms of trade.. The risk to the bond market is if the currency weakens much further from these levels.
c) Global yields. The US appears to have reached the peak in their rate hike cycle, which has led to a small rally in global bonds. Bond markets are concerned that global growth is slowing and as such have started to rally.
d) Supply of bonds. Government finance figures continue to improve with revenue collections running well above budget. This could well lead to the reduction in the weekly government auctions and thus a shortage of stock. This has led to the flattening of the SA yield curve with the longer dated bonds outperforming the short dated bonds.

The outlook for bonds is still one of caution as we head towards year end. Inflation will remain at current levels for the next couple of months, but then will continue to rise and will breach the upper band of the inflation target during the first quarter of 2007. This will ensure that the SARB will remain vigilant and we will see further interest rate hikes. The weakness of the Rand will also cause inflation fears and keep yields from rallying. With the current account deficit remaining above 6%, it will ensure that the Rand remains extremely vulnerable to any global shocks.

The market will however be well supported into any sell off of yields due to the lack of supply of bonds. Furthermore, local investors are very underweight in there exposure to bonds. These investors are likely to increase their exposure as yields start rising to 9%. The global environment is a little more mixed. The US has paused in there cycle and the market is waiting for conformation that the economy is slowing. On the other side of the Atlantic, the European Central Bank continues to hike rates in order to ensure inflation stays under control. The oil price will remain key to the path in inflation, and with the recent fall in these prices we should see inflation moderating somewhat.

The Rand will thus remain closer to R8/$ than R7/$ and inflation will rise above the upper band early next year. The SARB will continue to hike rates by 50bpts at the remaining two MPC meetings this year. We, thus maintain a short duration position in your portfolio at present.

After a relatively quite first few months of 2006, the second quarter announced the arrival of a bear market in bonds. Yields sold off dramatically over the quarter and we saw the All Bond index return a negative return in both May and June resulting in the worst quarterly return since March 2002. This negative move was caused by a large sell-off in the Rand and a deteriorating investment climate amongst emerging markets. The bond market was surprised in June when the Reserve Bank hiked interest rates by 50 basis points as the governor warned the exuberant consumers to slow down their spending. The strong Rand over the last few years has led to an import boom in SA which has allowed our current account deficit to balloon above 6%. Historically, a current account deficit in excess of 5% has always led to a bout of Rand weakness.

The global environment added to the uncertainty as the new US Federal Reserve chairman made his mark on monetary policy. His statements were viewed as very hawkish and thus global markets started pricing in further rate hikes in the US. This led to a change in sentiment in emerging markets as investors started to re-price risky assets. Countries with current account deficits (like New Zealand, Turkey and SA) were hardest hit. The inflation story continued to be positive with the April CPIX inflation release coming in at 3.7%.This was not enough to appease the South African Reserve Bank (SARB) as they decided to focus on the robust consumer spending currently driving the economy. The growth in the amount of credit in the economy is clearly keeping the Governor awake at night. These factors as well as the large current account deficit were clearly the reasons behind the rate hike decision. Inflation and robust growth internationally has caused a united effort from central bankers to talk tough on monetary policy. This has seen quite a few

surprise rate hikes and in Turkey they have raised rates by 400 bpts in under a month. This shift in focus has led to and increase in yields across the board as well as an increase in spreads in riskier assets. This risk aversion trade has also led to an increase in credit spreads in SA. The credit market had traded down to yields that were too expensive as the market continued to price only the good news. With the rate hike as well as the change in sentiment we have seeing a normalisation of these spreads. At these higher spreads we are starting to see some value returning to the SA credit market. Your portfolio was conservatively positioned and was underweight duration for the quarter, and therefore outperformed the index over the period. After the initial sell-off in rates we continued to reduce duration in the portfolio as the outlook for interest rates deteriorated.

The market was quite volatile over the quarter which further allowed us some trading opportunities. The outlook for bonds continues to be uncertain, but with yields trading around 8.5% the market is starting to return to fair value. If the SARB hikes by the expected 100bpts over the remainder of this year we will see value in the 10 year bonds from 8.75% upwards. The SARB is going to continue to monitor the current account and credit growth closely and will adjust rates accordingly. We will thus closely monitor these trends to determine the correct positioning of your portfolio. The inflation outlook for the next year sees CPIX rise to just above the upper band of the inflation target.

This will mean that bonds will remain under pressure until the market feels that the worst is behind us. The global markets are also extremely vigilant for any inflation surprises and we expect the central bankers to continue with their hawkish bias for the next 3 to 6 months. We will maintain a short duration position in your portfolio, but will start accumulating some bonds into the current weakness. We foresee that there will be quite a few trading opportunities as the market tries to determine whether inflation will accelerate or not.

At first glance it would appear that yields did not move during the first quarter of the New Year. The bond market finished the quarter at similar yields to those of December 2005. Within the quarter there was some volatility and we saw yields trade down to historic lows (high in price). As expected the large coupon payments in February offered some support to the bond market and pulled yields down to around 7%. With cash rates also at these levels, it was not surprising that the longer dated bonds could not sustain these low levels, and thus we saw a small sell-off in yields towards the end of the quarter.

The Rand continued to trade within a narrow range and with the support from the higher gold price, made another assault on the R6.00/USD level. In March we saw some risk aversion return to emerging markets and this caused most of the currencies in the emerging market stable to depreciate. Despite this trend, the commodity prices continued to give the currency a strong under pin and we saw the Rand finish the quarter around R6.10/USD.
The inflation story continues to be positive with the February CPIX inflation release coming in at 4.5%, which was slightly lower than the market was expecting. While inflation continues to be a positive driver for the bond market, the continued robust consumer demand is pushing credit levels up to levels that caused the Governor of the Reserve Bank to warn the market that interest rates would need to be hiked if the economy showed signs of over heating.

The international front was more negative for our market as both the US Federal Reserve and the European Central Bank hiked their policy rates. Furthermore, we saw the Bank of Japan announce that they may also start hiking rates again. These hikes resulted in our market been kept in a narrow range.

The narrow trading range not withstanding, we still managed to outperform the ALBI with active management of the duration in your portfolio. We started the year with a positive outlook for the bond market and took a over weight duration position going into the budget. Once again the minister of finance delivered a positive budget and also reduced retirement fund tax. This caused the bond market to rally and we used this opportunity to take some profit and to reduce the duration position in your portfolio.

Other than the crucial duration decision, we also make use of various curve and slope strategies to enhance your fund performance. In particular our strategies for the flattening of the yield curve and the out performance of the 'humped' area of the curve in the 10-14 year maturity area continued to add extra performance. We did reduce this position over the quarter and now have a more neutral position across the curve.

The outlook for bonds is being driven by conflicting local and international forces. On the local front, inflation is benign and we forecast that we have seen the peak for this year at 4.5%. The next few readings could even be below 4%. This should make the SA Reserve Bank very relaxed about leaving interest rates on hold. However, the SA consumer is enjoying the low interest rate environment and is continuing to spend at a rate that is indeed causing some concern in the corridors of the SARB. We continue to expect interest rates to be kept on hold for the remainder of the year.

The international outlook is slightly different with most central banks being in a tightening phase which should put upward pressure on interest rates. As global rates continue to rise, our relative attractiveness diminishes, and we could well see some sell off of our bond yields. As a result of these concerns we are currently underweight in our allocation to bonds.

The Rand should continue to be supported by the commodity prices which will also lead to a more stable outlook for our bonds. Should bond yields sell off in the near term, we would use that opportunity to increase the duration in your portfolio as the outlook for interest rates in the second half of 2006 is positive. We will continue to actively manage the duration of the portfolio within the expected narrow range in yields.