Market review
The third quarter was dominated by the subprime housing crisis in the United States, widespread credit concerns and the growth prospects of the US economy. The general reluctance of banks to lend to each other was not confined to the US, and global banks saw a severe squeeze in liquidity. A full-blown implosion of the US credit market was narrowly averted when the US Federal Reserve (the Fed) first cut the rate at which it lends to commercial banks and later the benchmark federal funds rate, from 5.25% to 4.75%. Global government bond yields rallied hard from the beginning of July as the markets reacted to signs that policy tightening was starting to impact credit markets.

Domestically, we witnessed a modest slowdown in growth and evidence of somewhat weaker consumer spending, particularly evident in the motor vehicle retail sector. Rising inflation, mostly on the back of sharply higher food prices, and a pick-up in inflation expectations were met by a further interest rate hike in August.

Global events reflected in the SA market, causing bonds and the currency to weaken and equities to sell off as risk appetite waned and uncertainty with regard to the global outlook grew. However, the bears seemed to lose the battle yet again as US Federal Reserve governor, Ben Bernanke, provided some monetary relief.

Equities recovered strongly from their August lows, gaining 6.7% over the quarter. Bond and property yields pushed lower and the currency gained strongly against a falling dollar. Over the quarter the All Bond Index (ALBI) was 3.4% higher, listed property rose by 9.5% and cash (as measured by the STeFI) earned a return of 2.3%.

Fund performance
The Investec High Income Fund earned a return of 2.3% over the quarter, which was in line with cash. The fund was slightly behind the ALBI (1-3 year) Index, which returned 2.7%. This has been the best quarter for the bond market so far this year. Despite the continued higher inflation and global credit woes, yields rallied in September and are anticipating the peak in local interest rates.

The portfolio has been slightly short duration over the quarter and we have bought back some duration. Credit spreads continue to widen and as such we have not increased our exposure in this area.

Performance was helped in July and August by our underweight duration position and we outperformed the index. The sharp rally in yields in the latter part of September saw us lose ground to the index.

Portfolio activity
We traded the duration quite actively over the quarter. The fund started the quarter with duration well below one year and as yields rose we started accumulating bonds going into September. As CPIX continued to deteriorate we sold some duration during September. Due to the concern regarding global credit events our participation in local auctions was limited, although we did increase exposure to well priced securitisation issues.

Market outlook
The bond market is starting to look through the peak in CPIX inflation and is anticipating the end of this interest rate cycle. Even though inflation is forecasted to remain outside the targeted band of the South African Reserve Bank (SARB) for the next six to eight months, bond yields have already started to rally. Our view is that inflation will only peak next year and as such there is still a risk that yields will sell off again. The October monetary policy committee decision is too close to call and the SARB governor will hike interest rates if he solely looks at inflation. However, it is expected that he will have watched the global events with concern and may well decide to pause in order to ensure that this credit crisis has indeed passed.

The biggest risk to our portfolio is that the bond market continues to ignore the high inflation and starts to price in the chances of interest rate cuts by the end of 2008. We feel that the bond market has run ahead of itself and that there will be a better buying opportunity during this final quarter. Inflation is going to start rising again and yields should also rise.

Market review
Money market yields sold off aggressively in the second quarter, driven by the long end of the yield curve, which kicked up 0.88% during the period. With the deterioration in the inflation data over the quarter, the market had priced in a full 0.70% of further interest rate hikes prior to the June Monetary Policy Committee meeting. Therefore, the market was not surprised by the South African Reserve Bank's 0.50% increase in the repo rate at the beginning of the month.

Sentiment remained negative through most of the quarter helped by hawkish rhetoric from the South African Reserve Bank (SARB), domestic inflation data surprising on the upside as well as increased global inflationary concerns. Rising global yields coupled with a rise in volatility put pressure on riskier emerging market assets as investors demanded to be compensated for the uncertainty. Over the quarter the local government debt curve rose sharply with the benchmark R153 and R157 peaking at 9.15% and 8.58% respectively. Bonds underperformed cash. The All Bond Index lost 1.7% over the quarter while cash (as measured by the STeFI Index) earned a return of 2.2%. The All Bond Index (1-3 years) returned 0.7% over this period.

Fund performance
Over the quarter the Investec High Income Fund gave a return of 1.4%, outperforming its benchmark and the average fund in the sector. Your portfolio was correctly positioned for the sell-off in yields and held an underweight duration position throughout the quarter. We did buy back some duration, but are still underweight the benchmark. The portfolio benefited from being short duration as well as the positioning on the yield curve. As inflation expectations deteriorated, both the short end and the very long end sold off more than the middle area of the curve. Credit spreads did not perform well over the quarter and the slight widening of some of the corporate holdings in your portfolio detracted from the overall performance.

Portfolio activity
The portfolio started the quarter with an underweight duration position and a large allocation to cash. As yields rose we reduced the cash holdings by buying up some duration. Most of the buying of duration over the quarter was concentrated in the medium dated area of the curve. The corporate holdings were kept relatively unchanged. We merely sold some of the more expensive corporate bonds and bought some of the new instruments that were issued at higher yields.

Market outlook and portfolio positioning
The bond market is going to be fixated on the CPIX releases over the next few months. Since we broke out of the official inflation target band, there has been extra pressure on the SARB to hike rates. At present the market is pricing another 50 basis points hike in August and a 40% chance of a further 50 basis points hike in October. This would have seemed excessive a few months ago, but inflation fears have risen in most global economies and we have seen deteriorating inflation expectations across the globe. Real rates globally have also been rising which will keep our rates higher for longer.

The major causes of higher inflation have been food and fuel, but we are starting to see signs of 'pass through' inflation as retailers pass on higher costs to the consumer. This together with higher than expected wage increases will keep the SARB vigilant. On the positive side we are starting to see a slowdown in credit demand from the consumer as reflected in falling car and retail sales figures. This will be encouraging to the Governor as he has been warning consumers to reduce spending.

Our short duration position has been reduced and the portfolio is currently closer to neutral. We see some value in the bond market and as rates rise further we will start to build an overweight duration position. Thus, the biggest risk to our view is that inflation surprises on the upside and the SARB has to hike rates more aggressively. As inflation stabilises and growth in the economy moderates, we will see rates settle before rallying into the latter part of the year.

Market review
The South African bond market had a difficult month, losing 0.4%, which trimmed the quarterly return to a meagre 1.6%. Cash (as measured by the STeFi index) earned a return of 2.1% over the quarter, outperforming bonds. In the run up to the national budget, bonds priced in so much good news that they became vulnerable to any signs that the rate cycle might not have reached its peak. Credit and trade data suggested that the imbalances in the SA economy might be unusually tenacious. This was enough to convince investors that the monetary authorities might have to keep their finger on the interest rate trigger for a while longer. The rand weakened by 4.1% against the US dollar and 4.6% against the euro over the quarter.

Fund performance
The Investec High Income Fund gave a return of 2.1%, which was in line with cash. The fund also outperformed bonds (1.6%). The portfolio was reasonably active over the quarter. We increased the duration and bond exposure of the portfolio in early January in anticipation of a bond friendly budget and the seasonal coupon flows. The Minister of Finance did not disappoint and the unexpected budget surplus and the removal of the retirement fund tax caused bond yields to rally in February. We used this opportunity to reduce the bond duration substantially and shorten the money market duration. With cash expected to outperform bonds in the coming months we have increased our cash duration and remain cautious on bonds. Performance was helped by active management over the quarter and increasing exposure to the one year area of the cash curve. Bond yields continue to trade well below cash yields and in March cash comfortably outperformed bonds. Although we had a substantially reduced bond exposure this was still a drag on the overall performance of the portfolio.

Portfolio activity
The portfolio was active over the quarter as we had two positive months where bonds outperformed cash followed by a negative return month for bonds. The portfolio could thus increase the duration in January and February to benefit from the bond rally. We then reduced the bond holdings at the lower yields in order to protect the portfolio from some of the capital losses in March. Although we did not meaningfully increase the overall exposure to credits over the quarter, we did continue to add to exposure in attractively priced securitisation issues.

Market outlook
The inflation outlook has deteriorated on the back of rising global oil and food prices. These pressures will ensure that the South African Reserve Bank (SARB) remains cautious on interest rates for the foreseeable future. While there are some signs that consumer demand may be moderating, demand for credit remains at elevated levels. The SARB continues to use every opportunity to 'warn' SA consumers to curb their spending and reduce debt. Although we believe we are close to the top if the rate cycle, the risk of further interest rate hikes will persist. If oil prices suddenly moderated and food prices stabilised at current levels, the inflation outlook would improve sufficiently that the SARB could hold off on any further interest rate hikes. This could result in a rally in the bond market and thus our limited exposure would restrict our ability to outperform the benchmark. However, the portfolio's low overall duration position will give some capital protection in the event of a sell-off. The large cash holding is also giving the portfolio a higher overall yield due to the fact that bond yields are currently trading below cash yields.

The fourth quarter, although a very good one for bonds with returns of 5.55%, failed to be enough for the bond market to match, much less beat cash returns for the year. The SA Reserve Bank (SARB) hiked interest rates twice more over the three month period, 0.50% at each meeting, while we saw a significant Rand recovery and a big inversion of the yield curve. This meant that although we remained cautious duration on your portfolio for the quarter, correct positioning for the yield curve move and active management enabled us to outperform the benchmark.

The long end of the bond market rallied hard over the quarter as it looked through rising interest rates and higher inflation and responded to the strengthening Rand, lower oil prices and increasing risk appetite for emerging markets. The 2008 area of the curve was the pivot point with yields beyond that falling during the 3 month period, while cash rates moved higher. Active trading and positioning for the outperformance of the long end enabled your portfolio to outperform the index.

The immediate outlook for bonds is likely to be dominated by the change in the index and the positive seasonal pattern, offset by a little profit taking in emerging markets after a very strong fourth quarter and weakness is global bond yields. This combination should give rise to a reasonable trading range and outperformance of the long end. Concern about the current account deficit has receded for the moment, but it remains a long term structural overhang that makes the Rand susceptible to global shocks.

The shortage of government supply, combined with the significant lengthening of the index in the early part of 2007 will keep the market well supported into the budget in March. Furthermore, local investors have remained very underweight in their exposure to bonds and any increase in bond holdings will add further support to the market. As was the theme for much of 2006, the global environment remains a little more mixed. The US interest rate cycle may well have peaked, although recent signs of stronger economic activity and Federal Reserve comments are likely to keep market participants guessing in the months to come. On the other side of the Atlantic, reasonable growth will keep the European Central Bank vigilant. The oil price will continue to be a key determinant of the path of inflation, and if recent weakness persists will make the outlook for inflation into midyear more moderate.

The Rand is expected to remain largely range bound between R7.00-R750 in the coming months and inflation should rise close to the upper band in the second quarter. The SARB may well hike rates by another 0.50% at the MPC meeting in February, but this would probably be the final one in the cycle and the bond market will continue to look through the peak in both interest rates and inflation. We will thus maintain a position close to neutral and look for outperformance through trading volatility and the changing shape of the curve.