Developed bond markets generally recorded strong performances during the quarter. The biggest gain in yield was in the US, where the benchmark 10- year Treasury yield declined by a total of 56 bps from the high of 5.19% recorded at the end of June 2006. Treasury market bulls were comforted by a series of economic data releases, in particular on the housing market front, which enabled the Federal Reserve Board to pause with its policy tightening for the first time since July 2004. Another very important development for fixed income markets was a dramatic decline in the US dollar price of crude oil as tensions in the Middle-East subsided. This eased inflation concerns.
Locally, the benchmark R157 government bond (maturity 2015) traded in a wide range of 63 bps before closing at 8.63%, 2 bps below the closing yield at the end of the previous quarter. Sentiment swings during the period under review were caused mainly by worse than expected producer price data and rand weakness on the negative side; while bulls gained the upper hand on the back of sharply falling crude oil prices, strong global bond markets and a few other technical factors.
The fund stayed defensively positioned throughout the period. This is reflected mainly by the high cash holdings and a relatively low modified duration. We also deemed inflation-linked bonds an expensive asset and utilised market strength to switch to cash or near-cash assets as these are considered better investment alternatives on a risk-adjusted basis. We were fairly inactive during the quarter, apart from enhancing the fund's average yield by switching some government debt for new corporate sector debt. The current positioning is supported by an investment theme based largely on the risks of global liquidity tightening, high commodity prices and a large current account deficit. This is a combination we believe not to be supportive of lower bond yields in the short to medium term.

Market participants got increasingly anxious about the potential impact of higher short term rates on global growth prospects and global liquidity in particular during the quarter. As a result, both developed and emerging markets remained under selling pressure. The spread on emerging market, dollar-denominated sovereign debt, as measured by the JP Morgan Emerging Market Index, widened for a second consecutive month and is now approximately 65 basis points (bps) higher than its historical low recorded in the first week of May. The benchmark for global bonds, the US Treasury market, also weakened following renewed uncertainty about the extent of further policy tightening by the Federal Reserve Board.

At home, both the rand and interest rate markets weakened quite dramatically against the background of the 50bp rate increase by the central bank and worsening global sentiment. The yield on the benchmark R157 government bond reached a weakest level of 8.98% - more than 120bps higher than the previous month's close. Money market rates also rose; with short term rates up 65bps in reaction to the repo rate increase and 12-month NCD rates moving 130bps higher before settling slightly lower at month-end.

The fund reduced its high cash holding by increasing the fund's exposure to fixed rate government bonds into the recent weakness. We also managed to increase exposure to new corporate bond issuance at attractive levels.

We believe that the June rate increase was the correct policy action. Although global risk aversion could still cause some weakness in the short term, the bond market is offering better value at current levels, given our benign longer term inflation outlook.

During the month under review, market sentiment continued to sour, caused mainly by falling risk appetite. Uncertainty about the much anticipated peak in US short term interest rates was one of the most important drivers. As a result, local bond yields increased while the yield curve steepened at the same time. The benchmark R157 government bond traded to an intra-month high of 7.51% or 18.5 basis points (bps) higher than the February close.

We reduced bond exposure and modified duration by a significant amount following the February Budget Speech and thus managed to limit capital loss to the fund. Subsequent weakness was utilised to start increasing exposure at better levels given a more benign short term view. This included investment in both short and longer dated new corporate debt (namely Imperial Bank and ABSA Bank). Following the inflation-linked bond rally of the last few weeks, we also thought it prudent to reduce holdings of these bonds significantly, given the view that the current level of real yields is unsustainable.

We will cautiously monitor market conditions over the next few weeks, given that global sentiment is still quite fragile. For this reason, modified duration and yield curve tilts will be maintained at modest levels in favour of higher cash holdings. However, an expected benign near-term inflation outlook does offer a potential short term opportunity to increase the duration of the fund.

The single most important story for the bond market during the fourth quarter was the change in inflation expectations. At the start of the quarter the authorities were making increasingly hawkish noises about raising interest rates if higher oil prices were to have any second-round inflation impact.

Money market rates began pricing in what seemed an inevitable rate hike in December and bond yields also moved higher. We differed in our view, as we held a much more benign inflation outlook, and saw the market as being too pessimistic. Our positioning on the back of this contrary view helped the performance of the fund since towards the end of the year inflation expectations turned around completely when inflation surprised on the downside. Within a month, the expected peak in inflation had shifted from February 2006 towards the end of 2006 and the Reserve Bank's rationale to hike in December or February fell away completely.

The fund's moderately long duration thus worked in its favour when bond yields firmed to historical lows during December. Yields benefited from the fact that rate hikes in the near future were likely, good inflation figures and a strong rand.

Wikus Furstenberg took over management of the fund on 1 January 2006.