On the 1 November 2003, the African Harvest Bond Fund and the BoE Bond merged to form the Nedbank Bond Fund. The history of the African Harvest Bond Fund has been retained. This fund is part of the Active Return Range.

After two months of flat performance, September provided all the performance for the quarter. The benchmark All Bond Index (ALBI) had a return of 2.68% over the period. The short-end of the yield curve came down sharply on the back of the reduction in money market rates. The long-end also came down but we had an upward move in the curve in the medium term area. This resulted in the 1-3 year area returning 2.86%, the 3-7 year area 1.89%, the 7-12 year area 2.48% and the 12+ year area being the best performing area with a return of 4.43%.

As a result of the large exposure to the medium term area of the yield curve, the worst performing area over the quarter, the fund underperformed the ALBI with a return of 2.06% over the quarter. This is a complete reversal of the previous quarter. On a relative basis the fund had a poor quarter coming 14th out of 21 competitors. Over six months, however, the fund is still ranked 2nd.

Economic Overview
The pace of local economic expansion continued to wane over the second quarter with real gross domestic product expanding by a seasonally adjusted and annualised 1.1% following 1.5% over the preceding quarter. But the latest numbers confirmed the local economy’s 19th consecutive quarterly expansion, the longest period of unbroken expansion on record.

The production side of the economy remained weak over the quarter as key sectors like manufacturing continued to haemorrhage under the strain of rand strength, lacklustre global demand and last year’s interest rate hikes. Local demand remained buoyant on firm consumption and fixed investment spending. Household spending remained firm, buoyed by tax cuts, government transfers, real wage gains and increased debt.

Inflation continued its sharp decline from peak rates recorded over the fourth quarter of 2002, driven lower mainly by lower food prices and the sharp appreciation of the rand in 2002. Consumer inflation - measured by the annual percentage change in the CPIXu - fell to 6.3% in August from a peak of 11.3% in October and November 2002. Notwithstanding the rand’s continued strength there are increasing signs that inflation may be nearing its bottom.

The Reserve Bank has eased its benchmark Repo rate by 350 basis points since mid-June to 10%. Over the remainder of this year the Reserve Bank will cut rates again. But the current easing cycle does not imply a material loosening of monetary policy. Real rates remain restrictive, as it should given significant medium-term structural inflation bugbears. These include high and sticky administered price inflation and rising unit labour costs.

Market Background

The past quarter saw a fair degree of volatility. During July and August long bond rates generally moved up on the back of rising United States bond rates which rose from a level of 3.5% at the end of June to a high of 4.6%. This upward move in our rates occurred notwithstanding a cut in the Repo rate of 100 basis points in August. During September, we saw a retracement as the growth numbers came in lower than expected and the South African Reserve Bank surprised the market with a special Monetary Policy Committee meeting at which the Repo rate was reduced by a further 100 basis points. This move was supported at the end of the month by lower than expected Producer Price Inflation, money supply and credit extension numbers. The strength of the rand also added fuel to this fire dropping to below R$7 from a level of R$7.46 at the beginning of the quarter.

The end result of these moves is that we are currently sitting with a yield curve that has normalized meaningfully, particularly with the short rates that have moved down significantly - see the graph below. The very long-end has surprised with its strength and the medium area of the yield curve is in fact higher than it was at the beginning of the quarter. This is illustrated by the R150 (2005) having fallen from 8.89% to 8.42%, the R153 (2010) having risen from 8.97% to 9.15% and the R186 (2026) having fallen from 8.90% to 8.55% over the quarter - see the graph below.

The corporate bond market was fairly active this past quarter with the issuance of R9 billion of new debt. It took place largely in the five-year area and included AngloGold, Sasol, Unilever and Abil.

The money market responded dramatically to the cuts in the Repo rate with the three-month NCD rate declining 235 basis points from 11.40% to 9.05% over the quarter and the 12-month rate declining 130 basis points form 9.90% to 8.60%.

Portfolio Overview
Throughout the quarter, the fund’s duration remained shorter than the benchmark ALBI and over-exposed to the 3-7 year area of the yield curve.

Performance Summary
Another great quarter for bonds! The benchmark All Bond Index (ALBI) had a return of 6.74% over the quarter. The major change from previous quarters has been the first large moves toward a normalized yield curve. This resulted in the 1-3 year area returning 6.00%, the 3-7 year area 8.19%, the 7-12 year area 7.84% and the 12+ year area being the worst performing area with a return of 5.32%. The normalization of the yield curve can be seen in the graph below. The fund comfortably outperformed the ALBI with a return of 7.56% over the quarter. This outperformance was achieved notwithstanding a duration that was shorter than that of the benchmark. It was largely as a result of the yield curve positioning of the fund. The fund was heavily overweight the 3-7 year area, the best performing area of the yield curve and heavily underweight the 12+ area, the worst performing area of the yield curve. On a relative basis the fund had a very good quarter coming 2nd out of 21 competitors [Source: Micropal].

Economic Overview
The local economy continued to put in a solid performance recording its 18th consecutive quarterly expansion in the first quarter of 2003, although the performance was more subdued than in the fourth quarter of last year. Real gross domestic product - the broadest measure of output in the economy - grew at a seasonally adjusted and annualised rate of 1.5% in the first quarter compared to 2.4% in the fourth quarter. On a year ago, GDP grew by 2.6% in the first quarter compared to 3.0% in the fourth quarter.

The production side of the economy was noticeably weaker over the quarter as key sectors like manufacturing buckled under the strain of rand strength, lacklustre global demand and successive interest rate hikes in 2002. Local demand remained buoyant as households were in a better position to withstand last year’s monetary tightening, government continued to expand consumption and investment, and private fixed investment continued at a strong pace.

Inflation peaked in the fourth quarter of 2002 and has been declining sharply since then, driven mainly by lower food prices and the sharp appreciation of the rand in 2002. Consumer inflation - measured by the annual percentage change in the CPIXu – fell to 7.7% in May from 8.5% in April and a peak of 11.3% in October and November 2002. Inflation will continue falling over 2003 on lower food prices, the firmer currency and last year’s high bases.

Despite these cyclical positives for inflation over the next few months a number of structural bugbears remain. These include high and sticky administered price inflation and the impact of deteriorating inflation expectations as evidenced by rising unit labour costs. Thus, the Reserve Bank is likely to keep monetary policy fairly restrictive, allowing rates to decline in nominal terms while maintaining high real rates.

Market Background
The major event over the past quarter was the first step by the Reserve Bank in beginning to unwind the four percentage point hike in official interest rates we had during 2002, after the rand crisis at the end of 2001. On the 12th June the Reserve Bank reduced the Repo rate by 150 basis points from 13.5% to 12.0%. This cut in the Repo rate would have been made in the belief by the Reserve Bank that they were likely to meet their inflation targets going forward. This was against a backdrop of:

better than expected Producer Price Inflation:
a further recovery of the rand from R$7.92 to R$7.51 over the quarter:
a better than expected Consumer Price Index after an unexpected revision of the these numbers when Stats SA admitted that they had significantly overstated these numbers due mainly to an incorrect calculation of rental increases:
a slowdown in the growth of the economy; and
an end to the Iraq war.

This cut in the official rates led to a further sharp reduction in bond rates with the benchmark R153 (2010) bond declining from 10.18% to 9.07% (111 basis points) over the quarter. Even more significant has been the rapid normalization of the yield curve, as can be seen in the graph below. The R150 (2005) bond declined from 10.95% to 8.88% (207 basis points) over the quarter. Other than for the very short end of the yield curve we now have a positively shaped yield curve.

The only new issue in the corporate bond market this past quarter was the Eagle Bonds One (Pty) Ltd, which is a South African lease receivable transaction guaranteed by an Export-Import bank of the United States. The issue is AAA rated by Moody’s.

The money market also responded dramatically to the cut in the Repo rate with the three-month NCD rate declining 185 basis points from 13.25% to 11.4% over the quarter, the six-month rate declining 275 basis points from 13.15% to 10.4% and the 12-month rate declining 290 basis points form 12.8% to 9.9%. These rates would appear to be building another 300 basis points in cuts in the Repo rate over the next six to 12 months.

Portfolio Overview
Some short-term trading was done for the fund, but on balance the duration of the portfolio remained shorter than the benchmark ALBI and overexposed to the 3-7 year area of the yield curve over the quarter.

Outlook
Looking forward, we believe that the Reserve Bank is likely to continue cutting the Repo rate over the next six to twelve months. This should result in the further normalisation of the yield curve. We will continue favouring the shorter-to medium-area of the yield curve, as we believe that area should benefit most from the further normalisation. We will also continue running the portfolio at a duration that is shorter than the ALBI benchmark as there is the risk that particularly the longer-end of the yield curve could start moving up as the normalisation unfolds further.

Performance Summary
The benchmark All Bond Index (ALBI) had a return of 1.39% over the month with the 1-3 year area returning 1.09%, the 3-7 year area 1.66%, the 7-12 year area 1.59% and the 12+ year area 1.28%. This is consistent with a yield curve that is starting to normalize with the short-end still being held up by the official rates, as can be seen in the graph below. The Bond fund meaningfully outperformed the ALBI with a return of 1.72% over the month. This outperformance was as a result of the fund being overweight in the two best performing areas of the yield curve, the 3-7 and 7-12 year areas, even though the duration of the portfolio was shorter than that of the benchmark. On a relative basis the fund also had a very good month being positioned 2nd out of 21 competitors.

Market Background
The CPI (x) numbers, monitored by the Reserve Bank for inflation targeting purposes, disappointed the market in as much as a level of 12.0% was expected for March and the outcome was 12.5%, in line with the previous month. The PPI numbers did however, continue to surprise on the positive side. The market was expecting a level of 5.3% and the actual outcome was 5.1%, compared to the previous month's level of 6.2%. We saw a continuation of the improvement in the rand, particularly to the dollar, strengthening from a level of R$7.92 last month to R$7.1% at the end of April. These factors resulted in the benchmark Government bond, the R153 (2010), declining from a level of 10.19% to 10.00% over the month. The longer dated money market rates have also started declining in anticipation of a decline in the official rates with the six-month rate declining from 13.15% to 13.05% over the month and the 12-month rate declining from 12.8% to 12.65%.

Significantly, what has been happening to the yield curve, as mentioned above, is that we are beginning to see the unwinding of the significant inversion that we have been living with since the beginning of last year, when money market rates started moving upwards. Again, it can be seen in the graph below that the three- to ten-year part of the yield curve moved down more significantly than the rest of the curve.

Portfolio Overview
The portfolio duration was increased slightly over the month from 4.06 to 4.19 by purchasing R2 million R194 bonds. We also did some short-term trading, by buying and selling R4 million R153 bonds. The fund remains particularly overweight in the 3-7 year area of the yield curve.

Outlook
Looking forward, we believe that the Reserve Bank is likely to cut the Repo rate at the next MPC meeting that is scheduled for June. This should see the further normalisation of the yield curve. For this reason, we favour the shorter to medium area of the yield curve, as we believe that area should benefit most from the normalisation. We will continue running the portfolio at a duration that is shorter than the ALBI benchmark.

Performance Summary
The benchmark All Bond Index (ALBI) had a return of 4.77% over the quarter with the 1-3 year area returning 2.98%, the 3-7 year area 4.45%, the 7-12 year area 5.40% and the 12+ year area 5.82%. This is in line with expectations when looking at the graph below where one can see that other than for the short-end, the yield curve moved down in a parallel shift. With the greater duration of the longer bonds it was the longer bonds that performed the best. The fund slightly underperformed the ALBI with a return of 4.63% over the quarter. This underperformance was as a result of the fact that during a period of declining interest rates the duration of the fund was shorter than that of the ALBI as well as being underweight the 12+ area, the best performing area over the period.

Economic Overview
The South African economy recorded its 17th consecutive quarterly expansion in the final quarter of 2002, making the current upcycle in activity the 4th longest on record. This was despite a continued moderation in growth momentum due to higher interest rates, the firmer currency and lacklustre global demand. Real gross domestic product grew at an annualised rate of 2.4% in the fourth quarter compared to 2.9% in the preceding quarter. A year ago, GDP growth rose by 3.0% in the fourth quarter compared to 3.2% in the third quarter. For all of 2002 the economy expanded by 3.0% compared to 2.8% in 2001. The key driver of activity remained buoyant local demand, especially fixed investment spending.

South Africa's current account registered a surplus of R4.3bn annualised (0.4% of GDP) in the fourth quarter after a deficit of R2.2bn (0.2% of GDP) in the third quarter. For the year a surplus of R3.3bn (0.3% of GDP) was recorded compared to a deficit of R2.8bn (0.3% of GDP) in 2001.

Inflation peaked in the fourth quarter of 2002 and has been declining sharply since then, driven mainly by lower food prices and the sharp appreciation of the rand in 2002. Consumer inflation - measured by the annual percentage change in the CPIXu - fell to 11.3% in February from 11.8% in January and a peak of 12.7% in November 2002. Inflation will continue falling sharply over 2003 on lower food prices, the firmer currency and technical factors. Despite these cyclical positives for inflation over the next few months a number of structural bugbears remain. These include high and sticky administered price inflation and the impact of deteriorating inflation expectations as evidenced by rising unit labour costs. Thus, the Reserve Bank is likely to keep monetary policy fairly restrictive, allowing rates to decline in nominal terms while maintaining high real rates.

Market Background
The past quarter has been another good period for the bond market. The major driving force behind the good returns has been the rapid unwinding of inflationary forces as seen in the Producer Price Index (PPI) numbers where they have surprised on the positive side for each of the past three months. PPI has now come down from a high of 15.4% in September 2002 to 6.2% in February 2003. This has been driven largely by declining agricultural prices and supported by the strengthening rand. Over the quarter the rand appreciated from R$8.64 to R$7.92. Statements from the major international rating agencies that they were upgrading the outlook for the country's credit rating also supported the strength in the bond market. Long bond rates, as represented by the R153 (2010) Government bond, declined from a level of 10.73% at the end of December last year to a level of 10.18% at the end of March.

There has been some activity in the corporate bond market this past quarter with two issues in March. Daimler Chrysler issued R1 billion in the five-year area at a spread of 103 basis points above the Government curve and Investec issued R1 billion 10-year subordinated debt at a spread of 213 basis points above the curve. The only other new issue this past quarter was the Development Bank of Southern Africa that raised R1.5 billion in the 20-year area at a spread of 40 basis points above the curve.

The money market largely moved sideways over the quarter with the Governor of the Reserve Bank at an early stage in the period warning that rates were not going to be coming down too quickly. This was confirmed at the March meeting of the Reserve Bank's Monetary Policy Committee (MPC) where the Repo rate was left unchanged. The 12-month NCD rate remained unchanged at 12.8%, as did the three-month NCD rate at the level of 13.25%.

The SA economy maintained its robust pace over the third quarter, buoyed by local demand as exports faltered. Gross domestic product grew at an annualised rate of 3.0% over the quarter after upwardly-revised growth of 3.0% and 3.8% over the second and third quarters respectively. On a year ago, GDP growth rose by 3.3% over the third quarter compared to 2.7% and 2.3% over the first and second quarters respectively. Investment spending growth remained strong, expanding by 8.7% annualised over the third quarter. Consumer spending growth gained 2.9%, supported by gains in spending on durable goods. The buoyant pace of consumer spending growth is expected to taper off due to successive interest rate hikes.

South Africa's current account registered a deficit of R4.8bn annualised (0.4% of GDP) in the third quarter compared to a surplus of R3.1bn (0.3% of GDP) in the preceding quarter. The deficit was due to lower exports and continued dividend-related outflows.

Inflation remained a major bugbear on the back of the rand's sharp deterioration in 2001, rising food and energy prices and sticky administered prices. Consumer inflation - measured by the annual percentage change in the CPIXu - rose to 12.7% in November from 6.5% in December 2001. The deterioration in inflation and the substantial risks to meeting the price targets over the next two years prompted the Reserve Bank to hike rates by 400 basis points since January.

Bonds Market Movements
After an initial scare during the early part of October when the inflation numbers came through fairly negatively, the bond market, driven by a very strong rand (R$10.55 to R$8.59), performed very well over the quarter. The benchmark R153 (2010) government bond declined from a level of 11.88% at the end of September to a level of 10.74% at the end of December. A similar pattern was seen for all the government bonds across the yield curve. As can be seen from the graph below the Bond Exchange of South Africa yield curve moved down with a fairly parallel shift over the period, but with the shorter end moving down further than the longer end. This resulted in the yield curve becoming less inverted by flattening somewhat.

The All Bond Index produced a return of 7.55% over the quarter. Within this the best performing areas were the 7-12 year and 3-7 year areas with returns of 8.67% and 7.95% respectively. These also happened to be the areas to which we were over-exposed. The 12+ year area had a return of 7.46% and the weakest performing area was the 1- 3 year area, which had a return of 5.39%.

Looking forward, we believe we are at or near the peak in the inflation cycle that should create scope for the Reserve Bank to start reducing short-term rates some time during the second or third quarters of 2003. It remains unlikely that the inflation target for 2003 will be met, but with the 2004 target having been revised upwards, it is now possible for that to be realised. We are of the view that bond market rates remain over-optimistic and as a consequence we are maintaining our bond portfolios at a duration that is shorter than that of the All Bond Index.