During the quarter, the fund benefited initially from an increased exposure to long duration bonds, and again from a lightening of exposure towards the end of the quarter as the inflation outlook deteriorated. In addition, active yield curve risk positions added to the fund's performance, with exposure to the short end of the yield curve being extremely limited in the run up to the September rate hike.

Towards the end of the quarter the fund managers again increased the funds xposure to offshore assets as they have become increasingly wary of the prospects for the rand over the remainder of the year. Unfortunately, this will also impact negatively on the next income distribution due to the low yield nature of developed markets. The potential capital gain should however compensate for this.

Domestically, the prospects for bonds are not great, and the fund has been positioned to take advantage of short term rates staying higher for longer. This should ensure that the fund delivers high returns with a low risk strategy.

This is the most flexible of the fixed interest range of funds. It has moved from being the most aggressively positioned fund in late 2001, to being focused primarily on capital preservation in the first quarter of 2002.
However, two developments that took the fund manager's by surprise over the quarter were the entrance of foreign investors into South African bonds, and the unusually large appetite for R186 bonds by local life assurers. The result was that bond yields rallied almost 150 basis points in little over three weeks, before settling into a consolidation pattern for the rest of the quarter.
As the fund was positioned too conservatively, the fund missed out on making substantial capital gains from the rally. Having the flexibility to move the fund from aggressive to conservative, and vice versa, means that the fund manager's were very disappointed by the relative performance over the quarter. However, the fund manager's do believe that, over time, they will make more correct calls on the market than incorrect ones.
Furthermore, the fund manager's also tend to position the fund so that there is always an underlying conservative bias to investment strategy and portfolio construction. This need not necessarily signify underperformance as the flexibility available should mean that more opportunities are available than a normal income fund. The fund manager's also believe that the fund, although disappointing for the quarter, will continue to benefit from a judicious management of the interest rate cycle to maximise potential capital gains whilst also delivering consistent income levels.

In January 2002, the Reserve Bank surprised the market with a 1% hike in interest rates. This was largely driven by the impact on inflation caused by last year's Rand depreciation, and more importantly the impact on inflation expectations. These expectations had increased substantially and have to moderate if the Reserve Bank is to meet its 2003 target. Already it is clear that the 2002 target will not be achieved. Again in March, the Reserve Bank raised rates, citing identical reasons.
Over the quarter, the country continued to see weakness in the bond market with the R153s ending at 13.20%. Furthermore, the country saw a flattening of the yield curve. This is often indicative of an environment in which investors expect little or no growth and inflation to remain under control.
Internationally, the global economy looks set for a strong recovery this year. Already, markets have started to price in rate hikes by as early as the second quarter. However, the fund manager does not believe that the global recovery is guaranteed, particularly if oil prices remain at high levels. Furthermore, global inflationary pressures continue to remain muted providing no urgent need to raise rates. Thus, the fund manager anticipates that the major central banks will only start to increase rates in the third quarter. This backdrop provides very little support to bond yields internationally.
Locally, the market expects at least one more interest rate hike in June. The possibility of further increases during the year will depend upon whether inflation continues to surprise on the upside, and on whether inflation expectations remain high.
Inflation is only likely to peak in the third quarter of the year. Until then, bond yields are expected to trade weaker. The absolute levels will continue to be constrained by the lack of supply of paper in the market. Once again, the quarter presents low expectations of capital gains, with the focus on opportunistic type gains with consistent income levels.

The Strategic Income Fund was launched on 2 July 2001 and has been positioned for capital preservation, with little exposure to long duration or higher risk securities. A bond friendly environment is expected to continue as concerns around inflation decrease.