The third quarter was a favourable one for global bond yields. A perceived benign US inflation environment and a slight downturn in US growth resulted in investors becoming less concerned about a rapid increase in short term rates in the US. This created a positive backdrop for emerging markets and helped the rand remain at strong levels. The strength in the rand and a better than expected South African inflation environment prompted the SARB to cut interest rates a further 0.50% at the August MPC meeting. After a lacklustre performance for the first six months of the year, these factors led to a rally in bond yields over the quarter, with the ALBI returning 6.9%, but only 7.04% year to date and not substantially ahead of the cash return of 6.00% for the same period.
The interest rate cut and rally in bond yields were both positive factors for the property market. Given our view that the cyclical risk/reward trade-off for bonds is unattractive at current levels at this stage in the cycle, we have used the rally in both the bond and property markets to reduce the market risk of the fund and lock in and protect the capital gains that have been realised thus far. This has resulted in an increase in the weighting of money market investments and a reduction in the market risk, or modified duration, of the fund to less than one year.
The fund is therefore currently defensively positioned and will be exposed to very little capital loss as bond yields rise. We have also increased exposure to inflation linked bonds which should perform well relative to cash and nominal bonds over the next year, and also provide an attractive hedge in the portfolio should inflation surprise on the upside. The risks that inflation going forward might be higher than currently expected by the market have increased. This is given the backdrop of continuously high oil prices, soaring consumer demand and a steadily worsening current account deficit which leaves the rand vulnerable to any changes in global risk appetite.
The Strategic Income fund has returned 8.00% year to date, above both cash and bond returns for the same period.

The Strategic Income Fund remained conservatively positioned throughout the period as longer dated bond yields continued to rise, driven by market concerns over inflation and the SARB's interest rate response. This was coupled with a move higher in international bond yields as an improving employment picture in the US and the emergence of global inflationary pressures resulted in higher interest rates being priced into US bond yields. Additional pressure on domestic yields came from an increase in supply from government and the corporate sector, which is unlikely to abate throughout the remainder of the year.
We have favoured the shorter end of the yield curve over the quarter, and have built up term structure in the fund by investing in a range of money market instruments and shorter dated bonds. This has allowed the fund to lock into market expectations of higher interest rates which at times during the quarter were up to 1.5% higher than our forecast. This positioning has been particularly beneficial, with the appreciation of the rand towards the end of the quarter resulting in market expectations of interest rate increases being reduced.
We have kept the overall exposure to property relatively unchanged over the quarter, but with the rand back to its strongest levels on a trade-weighted basis since the beginning of the year, we have once again increased our exposure to Liberty International. This will stand the fund in good stead should the rand begin to depreciate from its current strong levels.
We continue to feel that, at current levels, longer dated bond yields are not attractive, and will look for more attractive entry levels as inflation and US bond yields move higher over the course of the year, and emerging market spreads unwind from their current tight levels as international risk appetite abates.

The fund's aim is to provide a high level of income as well as to seek opportunities to make, and subsequently protect, capital gains. Thus, the fund manager's reduced the funds exposure to bonds as yields rallied throughout the quarter, and increased the funds exposure to short dated investments to protect the fund's capital.

The fund manager's have retained the funds exposure to high quality corporate bonds which provide an attractive yield yet, bearing in mind liquidity restrictions, are reluctant to increase the funds exposure to corporate bonds significantly at this stage. The fund manager's have therefore kept the funds corporate exposure relatively unchanged throughout the period.

The fund manager's expect a moderate rise in bond yields over 2004 as CPIX passes its cyclical low and the international environment turns less favourable for bonds. Added to these concerns, increased government funding requirements should result in a steepening in the yield curve over the course of the next few months. This view has prompted the fund manager's to favour shorter dated bonds in the portfolio at this stage.

The fund manager's have slightly increased exposure to selected good quality property counters throughout the quarter. These were attractively priced from a valuation perspective, and will enhance the yield earned on the portfolio. The strength in the rand also gave the fund manager's an opportunity to slightly increase the funds exposure to Liberty International at attractive levels. This will prove beneficial for the fund should a depreciation in the currency materialise.