The bond market experienced significant swings in investor sentiment during the third quarter of 2011, most of it induced by foreign activity on the local bond market. During this period, the yield of the benchmark R208 government bond traded in a wide range of between 8.45% and 7.51%, before ending the quarter a mere 12 basis points stronger at 8.30%. We have opportunistically increased the RSA fixed rate and CPI-linked bond holdings into weakness, but retained the underweight tilt to modified duration.

Our investment view still centres on rising inflation and ongoing rand volatility, as concern about the Eurozone debt debacle continues to threaten global growth prospects, commodity markets and, by implication, the open South African economy. It is also worth noting that weaker growth prospects do not bode well for Government's tax revenue targets. Taking our cue from the most recent data, it is unlikely that the Minister of Finance will be in a position to offer good news in terms of the current fiscal year's budget deficit.

The overall position of the fund remains defensive, with a focus on short-term capital preservation while carefully considering potential investment opportunities into market weakness.

Fund positioning remained defensive during June, following the gradual reduction of short- and medium-dated fixed rate government bonds into market strength in the preceding two months. As a result, the currently lower total fund modified duration is at an appropriate level, given the more cautious investment outlook. Similarly, the higher cash and inflation-linked bond holdings tie in with our expectation of rising inflation and the start of the interest rate tightening cycle later this year.

The fund retained a defensive position over the last three months, with a small underweight modified duration tilt, some inflation-linked bond exposure and a high cash holding. To us, this is still the most appropriate investment strategy given our view on the interest rate cycle.

However, it is also vital to find a balance between capital preservation and earning a reasonable income. The yield curve is currently positively sloped, in other words long-dated bonds are trading at higher levels than short-dated instruments. This is in anticipation of rising inflation and monetary policy tightening, but also in reaction to the largest net funding requirement by the public sector since the first half of the 1990s.

Although it is still early days in terms of the widely expected rising interest rate cycle, it seems that the long end of the market is already pricing in some bad news. Taking into consideration the extent of yield curve steepness, we will be looking for investment opportunities in the months ahead. Investment action will focus on gradually building a holding of long-dated bonds into market weakness, and keeping an underweight tilt to short- and medium-dated bonds in anticipation of rising short-term rates.

The past quarter was characterised by significant weakness in the bond market, with most of the weakness occurring during the month of November. The All Bond Index (ALBI) produced a monthly return of 1.73%, and delivered 0.7% for the quarter ending 31 December 2010. This below-par performance was mostly on the back of the return of some minor risk aversion. During the quarter the South African Reserve Bank (SARB) cut the repo rate by a further 50 basis points (bps), which was expected by the market and, as a result, had limited impact. We maintained our underweight duration position during the quarter, although we used market weakness to reduce the duration tilt. In addition, we reduced exposure to the 12+ year area of the yield curve and added exposure to the 3-7 year area of the curve. We still maintain our underweight duration tilt on the view that there is further possible upside risk to bond yields.

Inflation-linked assets also had a poor quarter, with a return of 0.9% for the three months ended 31 December 2010. We utilised market strength to sell out our entire exposure to these assets, largely because the medium term outlook for the asset class is relatively unattractive.

Our yield enhancement strategy continues to add positively to performance. We will selectively add to our existing non-government exposure, because credit spreads had tightened to such an extent already.