Local interest rate markets rallied hard during the quarter ending September2008. A number of factors served as a combined catalyst for a sudden and very sharp turnaround in market sentiment. Most of the so-called volatility drivers of inflation, but in particular crude oil and food prices, started a sharp decline, while anecdotal evidence of a slump in consumer spending rose exponentially. Whereas the market at the end of June still priced with considerable certainty more interest rate increases, market participants had to re-position for the possibility of monetary policy easing on a 12- to 18-month view. Technical factors such as changes to the widely used bond index (on the back of net new issuance of long-dated debt and switch auctions with the same net effect) and the forced closure of short positions helped to create a temporary imbalance. The yield of the 10-year RSA government bond declined from a high of 10.85% to 8.78%, a level last seen in February2008.

We have increased the modified duration of the fund by investing mainly in the 7-12 and 12+ year maturity bands. We also re-invested cash in Eskom debt at the higher levels in anticipation of a narrowing of its yield respective spreads over the RSA sovereign curve. Market exposure was reduced at quarter-end on the back of short-term valuation concerns, as we believe that markets have priced a great deal of good news.

Events during June dealt another heavy blow to interest rate bulls. Confusion around the outcome of the Monetary Policy Committee meeting, renewed global risk aversion, another spike in crude oil prices, and disappointing local PPI and balance of payments data were some of the more important contributors. The net result of all this was another negative quarter for longer dated bonds, which at the end of June underperformed cash for the sixth consecutive month. The fund maintained a low modified duration with a particularly large underweight tilt in the 12+ years maturity band, and thus outperformed the BEASSA All Bond Index.

It is clear that higher inflation is going to be around for a while, with the peak in CPIX now expected in the quarter ending September 2008. Globally, concern about an economic growth slowdown, continued upward pressure on oil prices and renewed risk aversion can hardly be wished away, while locally sharply falling credit card transactions, vehicle and housing sales are firm indicators that higher interest rates are already stemming the consumer buying spree of previous years. These indicators are still overshadowed by the risks to inflation, hence the view that the repo rate should increase by yet another 50 basis points in less than two months.

The bond market weakened in the first quarter of 2008. The weakness was accompanied by a fair amount of volatility; predominantly as a result of rand depreciation, as well as more negative surprises from inflation data. The SA funding outlook also deteriorated, with higher government and parastatal funding requirements expected for this fiscal year - largely concentrated inlong-dated bonds. Foreigners also continued to be substantial net sellers of SA bonds. Globally risk aversion intensified, with continued concerns overa US and global growth slowdown, as well as ongoing problems in the USsub-prime mortgage market. This led to a further decline in US bond yields,as well as further increases in emerging market bond spreads.

Locally, yield curve normalisation received a boost from rising inflation uncertainty. As a result, cash and short-dated bonds outperformed mediumandparticularly long-dated bonds by a significant margin.

We reduced risk, as inflation continued to surprise on the upside, and maintained the large underweight tilt to long-dated bonds in anticipation of more yield curve normalisation. We also built up a small holding in inflation linked bonds. Due to the deteriorating inflation outlook, we will remain defensively positioned.

The bond market closed weaker for the quarter. The generally weaker trend was accompanied by a fair amount of volatility, as demonstrated by the wide yield range of 8.1% to 8.6% for the benchmark R157 government bond. The main drivers of weakness were a continuation of negative inflation surprises, the Reserve Bank's decision to raise the repo rate by 50bps at each of the October and December MPC meetings, and the steeply inverted yield curve, which severely hampered the sustainability of any bond rally in the absence of positive inflation news. Although the yield curve inverted during the quarter, cash, near-cash and short-dated bonds nonetheless outperformed long-dated bonds.

During the quarter, the fund maintained a defensive position after we reduced duration in October, mostly by increasing the underweight position in the 12 year + sector. This benefited fund performance and also assisted us in gaining relative performance. Looking forward, we believe that the market is still relatively expensive considering the risks of an uncertain inflation outlook and the steep negative yield curve slope. However, we also have to consider the impact of recent policy tightening on household consumption expenditure, the fact that bond yields have retraced and the potential impact of bond friendly developments such as bond index changes, coupon payments and the tabling of the National Budget in Parliament. This explains our decision at the end of December to change the large underweight duration tilt of the fund by increasing the bond holding in the seven to 12-year maturity band. In the short term, we may be looking for further buying opportunities.