Market participants had to deal with a fair number of negative developments during the third quarter. On the global front, sentiment was hurt by the subprime related events, which caused corporate and sovereign debt spreads to widen quickly and the bond yields of developed government debt to decline sharply. In the US, the Federal Reserve Board thought it wise to cut its benchmark short term interest rate by 50 basis points (bps), mostly in reaction to the sub-prime related woes.

Locally, investors also had to deal with worse than expected inflation data, which forced the South African Reserve Bank to raise the repo rate by another 50 bps at its August MPC meeting, causing the yield curve to steepen further. As a result, the bond market experienced a roller-coaster ride, which ended with a bull rally at the end of September in reaction to a better PPI number and a stronger rand thanks to dollar weakness.

During September, the fund largely maintained its position, except for utilising better buying opportunities in the corporate bond market as the bear market and lower risk appetite enabled investors to be more aggressive in bidding for assets. At month-end, we reduced duration risk, given the renewed inflation concerns, mostly by increasing the underweight position in the 12+ sector. For now, caution is prudent, especially considering the steep negative slope of the yield curve.

Global bond yields rose on evidence of strong economic growth, sticky inflation and a realisation that interest rates may stay higher for longer, while the global search for yield lost momentum as risk aversion received preference. Locally, the worsening inflation outlook exposed poor bond valuations, in particular that of long dated bonds. The central bank reacted to inflation uncertainty by raising the repo rate by 50 basis points. As a result, the yield curve shifted upwards, causing bonds to underperform cash by a significant margin.

During the quarter, the fund reduced exposure to interest rates by selling medium and long dated bonds. Our caution regarding bond valuation will continue until we get more clarity about the medium term inflation outlook or markets cheapen enough. During the quarter, net buying was limited to selected corporate bonds.

REVIEW OF Q1 2007 The money market outperformed both nominal and inflation-linked bonds during the first quarter of 2007. The yield curve of the nominal bond market normalised slightly, leading to underperformance by the 12+ sector of the All Bond Index. However, this masks significant volatility during the quarter. Toward the end of March, the bulls were forced to take cover, causing the market to retrace to a close of 7.84%.

Positive drivers during the period included the decision by the central bank to leave the repo rate unchanged, while also adjusting its inflation forecast to reflect a more benign outlook. On the fiscal side, the Minister of Finance announced a surplus budget as well as a reduced funding requirement. However, renewed concern about the near-term inflation outlook forced bond yields higher in March.

The fund remained fairly defensively positioned in line with the slightly bearish view that the combination of potential global liquidity tightening, some risk to high commodity prices and a wide South African current account deficit may not be supportive of lower bond yields in the medium term. As a result, the fund remained underweight in bonds in the 12+ sector of the index on valuation concerns. This was offset by an overweight tilt to cash and short/medium dated bonds.

We feel that long bond yields are at extended levels, particularly when compared to money market rates and considering that we do not expect short term interest rates to be reduced in the short term. There are also upside risks to inflation. As a result, we recommend a cautious stance to the bond market.

The combination of the repo rate increase totalling 100 basis points (bps) during the fourth quarter and a sharp decline in medium and long dated bond yields caused a significant inversion of the South African yield curve. The yield on the benchmark R157 (maturity 2015) declined by 78 bps to a best level of 7.85%, the lowest since June 2006 when the SA Reserve Bank started the current tightening cycle. In contrast, the overnight call rates and the yield on short dated money market assets rose in tandem with the increase in the repo rate. The net result was a significant outperformance by the medium and long dated bonds over cash and near-cash assets.

The strong bull rally was fuelled by a number of factors. Of these, foreign exchange markets had the most significant impact. A sharp weakening in the US dollar since October enabled the rand to regain some lost ground, which in turn improved perceptions about the medium term inflation outlook. Global risk aversion also improved markedly on the back of still highly liquid global conditions and a general belief that the global economy will experience a soft landing in 2007.

Locally, the Finance Minister surprised the market by announcing significant reductions in local funding requirements for the current and forthcoming fiscal years. Although local data releases lend support to the tightening of monetary policy, the bond market's reaction implies that investors generally expect current policy actions to have the desired effect and that inflation will be contained in the coming months.

The fund remained defensively positioned throughout the period. This is reflected mainly in its high cash holdings and a relatively low modified duration. We also deem inflation-linked bonds to be an expensive asset and utilised market strength to switch to cash or near-cash assets as 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 medium term, although we would concede that yields may drift lower in the short term, mostly as a result of technical reasons.