The 2nd quarter was another positive one for fixed interest investors building on the gains of the first quarter. Whilst the first quarter was driven by the Fed's extension of its "lower for longer" rhetoric (referencing low US interest rates through 2014), the 2nd quarter was driven more by local dynamics. The change in SA interest rate expectations has been nothing short of dramatic. At the beginning of the year, the market was expecting the SARB to hike rates by late 2012 or perhaps early 2013. Today, the market is pricing in a 90% probability of a rate cut within 9 months! The key to this change in expectations has been the topping out of domestic inflation, which registered 5.7% y-o-y in May 2012. Besides the weakish domestic demand environment, lower inflation was aided by the 26% decline in oil prices during the quarter and a slowdown in food price momentum. Fixed interest assets responded accordingly with the yield on the 10-year government bond dropping from 8.1% to 7.5% during the quarter. Bonds (+5.2%), property (+10.3%), income (+2.9%), ILB's (+1.5%) and cash (+1.4%) all produced positive returns.

In the context of this, the Fund produced returns in line with the income market and pleasingly outperformed the peer group significantly. Over the past 12 months the fund delivered a 9.2% return to investors, 0.88% higher than the average of the peer group, which we are delighted by given the re-launch of the Fund with new managers in April 2011. Relatively speaking Momentum Asset Management produced the highest return for the quarter given its higher exposure to property and longer dated bonds. Investec also benefited from longer duration bond exposure as well as its corporate credit exposure. Prescient produced positive, near benchmark returns, however lagged the other managers due to its lower duration portfolio and defensive positioning.

As postulated in our 1st quarter comment, we believe that the Fund is likely to outperform cash over 12 months and particularly so if the market expectation for a rate hike comes to fruition within the next 9 months. The Fund distributed 1.44c per unit to investors during the quarter, bringing the total income distributed to investors over the past 12 months to 6.05c per unit. This represents a 6.1% historic income yield for the year, and this together with the 3.1% capital return generated the total return of 9.2% highlighted above.

As expected, the SARB left interest rates unchanged during the quarter. Gill Marcus made some comments in March around inflation concerns, however, CPI numbers subsequently came in lower than expectations, and the FRA market is now pricing in the first rate hike to occur in Q2 next year. Inflation is currently hanging just above the top end of the SARB's inflation band at 6.1 %. Investment returns were strong over quarter, driven largely by improved sentiment from the liquidity boost to European banks by the ECB. The Fund performed reasonably over this period, producing a return of 2.8% and ranking 24th out of 46 funds in its sector. Over the past 3 years, the Fund has produced an annualised return of 10.5% per annum, ahead of its long term CPI plus 5% target objective of 10.2%. The Fund was ranked 11 th out of 38 funds in the targeted absolute and real return category during this time.
Absa was our best performing manager for the quarter, benefiting significantly from a large exposure to ILB's and property and good stock picking within equities. They have played the interest rate cycle well by maintaining exposure to retail shares in the face of valuations that appeared expensive. Although Coronation produced a good return, it is lower than their usual expectations due to stock selection not coming through for them yet. Prescient continues to struggle with the fixed interest portion of their portfolio having a short duration and its protection pay-away detracting. During the quarter we decided to tactically tilt the portfolio in favour of Absa and underweight Prescient until the environment becomes more suitable to their strategy. We are satisfied with the current positioning of the Fund.

Moving forward, it should be noted that it will be difficult to achieve inflation plus type returns in a negative real yield environment, such as we are currently experiencing (cash yields 5.3% vs. inflation of 6.0%). Rand strength during the quarter will provide some relief on the inflation front, but it has been volatile and is still at levels near the top end of its 3 year range. We are closely monitoring the rand, and would consider initiating a tactical allocation to foreign should the rand strengthen to a more attractive entry level point. Markets have continued to perform well on a more balanced economic outlook, but we believe that caution is now warranted with stocks trading at less attractive valuation levels and the potential for eurozone woes to come back into the spotlight. On this point, it is interesting to note that our managers have been trimming back their equity exposure recently.

2011 was a year of dramatic shifts in interest rate expectations. In the first half of the year, the Forward Rate Agreement (FRA) market had priced in the first interest rate hike by July 2011. By September this had reversed, with the FRA market anticipating a 50% chance of a cut within 6 months. And more recently, the FRA market is again anticipating a rate hike in the next 12 months, supported by the increase in inflation to above the SARB's targeted inflation band (+6.1% in 2011 following 3.5% in 2010). Ordinarily an increase in interest rate expectations would hurt interest rate sensitive assets, but the hunt for yield remains supportive of SA's fixed income assets. In addition, it seems that global bond investors are more concerned about tail risks to the global economy and are happy to pay a premium for the perceived safety of select sovereign bonds. Consequently, they have continued to buy into the SA bond market during the quarter, driving the yield on the SA 10 Year bond down to 8.1% by year end. Property (+3.7%), bonds (+3.5%), income (+2.2%), and cash (+1.4%) all performed well over the quarter.

So it was a good quarter for fixed income markets, and our portfolio participated well. It outperformed the average of its peer group, and over the last 12 months has produced a return of 7.9%. Momentum (previously known as RMB) was the primary driver of performance for the quarter, benefiting from longer duration positioning and significant exposure to ILBs. They also added value through their swap spread positioning.

Momentum is of the view that the depreciation of the rand in H2 2011 poses an upside risk to inflation, and hence believe a rate hike is likely to occur sooner than most think. They prefer the middle of the curve with a glut of government issuance keeping the long-end under pressure. They have a positive view on credit expecting spreads to grind lower. They continue to like the outlook for ILBs, but feel they may have run too hard recently. Looking forward, the global environment is interestingly poised between rising inflation and slowing growth with Europe being the major threat to global growth. It is difficult for us to get really excited about the fixed interest market in the face of rising inflation and the extremely low levels of global interest rates, however we are cognisant of the fact that further negative surprises and global growth scares will provide support to global fixed interest markets, including our own. We believe that the Fund is well placed to handle the type of volatility experienced by the market over the past year, and expect returns of between 6-10% from income orientated assets over the next 12 months.