The South African bond market had a lacklustre period over the quarter. Although the All Bond Index (ALBI) showed a positive return of 1.1%, this lagged returns achieved on not only equities (which outperformed bonds exceptionally, with the All Share Index (ALSI) returning 20.3%, but even cash (+1.8%). For the year to date, the ALBI has returned 5.5%, slightly lagging cash (+5.6%) and well behind the ALSI's 36.7%.

However, the star performer in the fixed interest universe (both this quarter and all year) has been inflation-linked bonds (which are not included in the ALBI). The Barclays SA Inflation-Linked Bond Index returned 14.1% in the year to end September and 4.0% in the third quarter (both comfortably ahead of the comparable period ALBI returns). The fund's holding of 6.3% in inflation-linked bonds during the quarter contributed to the fund's performance.

The generally sideways movement overall in the ALBI during the quarter masks some significant movement that occurred in the quarter. Indeed, in August there was enough momentum for bond yields to reach record lows, surpassing the previous low in February, helped along by Fitch and Standard & Poor's both upgrading SA's credit rating by one notch to BBB+ during that month. However, the positive sentiment did not last, as the market began revising inflation forecasts higher in light of rising oil prices, and started taking note of some more hawkish rhetoric coming out of the Reserve Bank. Whereas earlier in the quarter there was still some talk of the possibility of a further interest rate cut, by quarter end such expectations had all but disappeared and some market participants had begun to talk about the timing of an interest rate hike.

The benchmark 1 - 3 year sector produced a return of 1.23% for the quarter, while the fund managed a handsome outperformance of its benchmark with a 1.90% return. The reason for the outperformance can mainly be ascribed to the low risk strategy employed with respect to the bond market, where we maintain an underweight fund modified duration position in relation to the benchmark. We remain of the view that the current yield being offered in longer dated bonds do not provide sufficient compensation for the capital risk taken.

Although the corporate credit market continued to perform well, the phenomenal demand for these instruments seems to be slowing. The credit spread compression, where the additional yield received over and above that available for an equivalent duration RSA bond, has been slower than the previous quarter, resulting in lower capital gains. The corporate bonds continued to perform well returning 2.44% for the quarter. The fund took the opportunity to reduce its exposure to corporate bonds, to 9.3%.

We continue to believe that credit spreads in general are now too tight and do not provide adequate compensation for the risk being taken in many cases. During the quarter we took the opportunity to exit our investment in the Denel bond in light of the deteriorating credit fundamentals, and purchased the Liberty bond. Subsequent to its inclusion, the Liberty bond has had capital gain with a 10 basis point credit spread compression. We continue to monitor the credit quality of the portfolio and adjust our exposures accordingly.

We have, for some time, held the view that official interest rates are likely to rise in 2006. CPIX (inflation excluding mortgage interest rates) is beginning to pick up, from a low of 3.1% in February 2005 to 4.8% in August, as the weakness in the rand this year and higher petrol prices start taking effect. Food price inflation has remained very low, and this has helped offset the effect of rising petrol prices (CPIX excluding food was at 5.5% in August). We see inflation rising further next year, likely sailing close to the top of the Reserve Bank's 3% to 6% target range for CPIX. There is a chance that it will breach the top of the target range. Factors (other than the petrol price) that may see this happen include a less benign food price environment (maize futures prices have risen sharply in recent months), rising global inflation (affecting imported inflation) and a potentially weaker rand. There will be further pressure on input prices from above-inflation wage increases this year. With consumer spending so strong, there seems little incentive for retailers to try absorb a rising cost base into their margins. We thus still expect that cyclical pressures on inflation will probably see interest rates rise next year, but that this (especially compared to historic standards) will be contained, probably at between 1.5% to 2%.

We reiterate that our bearish view on inflation is a short-term, cyclical view, and that the structural improvement remains in place. But we emphasise that while we believe SA has in general moved into a structurally lower inflation environment, we cannot ignore the fact that inflation will still exhibit cyclical movements.

It also seems apparent that short rates are likely to remain flat in the near term, but the risk is for a rate hike into the second quarter of next year. On that basis, the portfolio remains conservatively positioned with capital preservation and yield enhancement paramount. However, the surprise element that could negate that view remains a strong rally in the rand which could force the Reserve Bank into a further round of easing.

Mark le Roux & Tania Miglietta
Portfolio Managers

Fixed interest market participants were once again taken by surprise this quarter at the South African Reserve Bank's (SARB) announcement of a further 0.5% repo rate reduction in April, taking it to a new low of 7%. The MPC left the repo rate unchanged in June, in line with market expectations.
SA bonds (ALBI) returned 5.29% for the second quarter. Recent better performance was due to high demand for local bonds (from foreigners) together with falling 10-year US Treasury yields. The US Treasury remained low, as inflation concerns from higher oil prices seem to be subsiding, and economic indicators are implying a slowing US economy going forward.
Corporate bonds performed well, returning 5.31% for the quarter. This was aided by spread compression, where the additional yield received over and above that available for an equivalent duration RSA bond, falls, due to re-pricing from high demand. This results in a capital gain. The Coronation Strategic Income Fund has 23% exposure in corporate bonds, holding those which still offer value. We believe that credit spreads in general are now too tight and do not provide adequate compensation for the risk being taken in many cases.
The star performing interest rate assets for the month were inflation-linked bonds. The inflation-linked index returned 6.97% for the quarter outperforming all other fixed interest asset classes. Strong demand with limited supply at the bond auctions has lead to aggressive bidding for inflation-linked bonds. Their yields, expressed as a real yield, fell by more than 30 basis points on average, resulting in a healthy capital gain to investors. The Coronation Strategic Income Fund holds 7.05% in inflation-linked bonds and will have benefited from these moves.
Domestic listed property performed very strongly over the quarter, with the index returning 11.7%. This performance was driven by a stronger bond market and continued good distribution growth from the listed companies. The quarter end exposure in the fund to domestic listed property was 3.68%. Given the strong run in share prices over the past quarter, we believe that some of the counters have reached and even exceeded our fair values. We expect that strong distribution growth will continue, but is now factored into many of the share prices. While we are forecasting that current excellent growth in property distribution will continue for the next three years, we do think that it would be incorrect to extrapolate this growth rate into perpetuity. We are currently in a very positive earnings cycle buoyed by strong consumer spending and economic fundamentals.
We introduced Makalani, a mezzanine finance provider as an alternative to cash and bonds, where returns below 7% remain unattractive. This investment is expected to yield in excess of 10% going forward.
Liberty International produced a good return over the quarter, and we have tactically reduced this holding on the back of a strong run in price. While this counter has underperformed domestic listed property in the year to date, we continue to believe that the diversification benefits added to the fund are meaningful.
Domestic economic releases for May showed that on many fronts the domestic economy is still powering ahead. Inflation, both at the consumer (CPIX 3.9%) and producer (PPI 2.4%) level is rising (with PPI having surprised on the upside). M3 money supply and credit extended were very strong figures proving that both the consumer and corporates continue to borrow and spend. Most analysts for the first time are conceding that there is a diminishing chance of further interest rate easing given these numbers.
Our short duration strategy still holds. We believe that bonds remain overvalued at these levels and that we will see better buying opportunities over the next few months (although these may be kept lower by foreign investor appetite).
The Coronation Strategic Income Fund continues to be conservatively managed, returning 2.83% for the quarter and 4.77% year to date, beating the 0 - 3 year bond index (3.63%), for the year to date.

At June quarter-end the fund had no conventional government bonds at all, and it sold its R153 call options. The 9% exposure to inflation-linked bonds and the below-average property holding proved to be useful, but unit holders pay a premium fee for what is now an enhanced money fund. Incoming manager Mark le Roux must raise the game.

Financial Mail - 05 August 2005

The Coronation Strategic Income Fund has had exceptional performance in 2005 by returning 0.26% for March (1.31% ahead of the fund benchmark which returned -1.05%) as well as 1.89% for the first quarter of 2005 (outperformance of 1.65% above the benchmark return of 0.24% for the first quarter).
Although the bond market started the year off by extending the rally seen in the second half of 2004, even reaching record low yields in February, our fears regarding the overvaluation of bonds were realised in March with the yield on the R153 rising almost a full percent from a low of 7.39% to 8.33%, before ending the month slightly firmer at 8.20%. The extent of the sell-off in bonds saw the All Bond Index (ALBI) lose 3.7% in March alone, dragging the overall first quarter ALBI performance into the red at -0.3%. The move seen was a bear steepening, i.e. the longer end of the yield curve fared the worst. In fact, the 12 years and over sector of the yield curve declined by some 7.7% during March, bringing the first quarter performance for that sector to - 1.7%. However, the shorter end of the yield curve was protected, with both the 1-3 and 3-7 year sectors returning a positive 0.2% over the quarter. Still, those returns far lagged cash which returned 1.9% over the quarter.
The trigger for weaker SA bond yields, not unexpectedly, occurred from global sources - fears of higher inflation in the US prompted investors to reconsider the likely magnitude of interest rate increases by the Fed, causing US Treasuries to rise as well as a change in the appetite for risk by global investors. This was evident in moves in emerging market currencies, including the rand, which were under pressure during March (with the rand weakening from 5.79 to 6.23 against the US dollar over the month).
Not surprisingly, these factors drove South African bond yields higher, together with some market acknowledgement of risks to future SA inflation as a result of the higher oil price, weaker rand and continuously high consumer demand.
We adjusted the composition of the Strategic Income Fund slightly during March in light of these moves:
1) A further decrease in our property weighting early in March in order to continue to lock in profits realised from the strength in the property market, given our negative outlook for bond yields;
2) A decrease in some of our exposure to preference shares in order to realise a portion of the capital gain earned;
3) A slight increase in our exposure to the government bond market via call options (which has increased the duration of the portfolio) in order to protect the fund should bond yields retrace to slightly stronger levels over the short term, without the risk of capital loss that physical bond purchases would suffer should yields continue to rise.
Despite the move seen in bond yields over the past month, the outlook for bonds is still risky given that the market is not fully discounting the risks of a further unwind in global risk appetite as the Fed continues to raise US interest rates, as well as domestic inflation pressures that will be unmasked should the trend of rand appreciation be at an end. Bond yields are still expensive at these levels and our investment stance within the fund is thus still conservative with an emphasis on low capital risk until the bond environment becomes more favourable.

The Strategic Income Fund has performed well throughout the year, returning 3.6% for the quarter (1.07% ahead of the benchmark) and 11.89% for 2004 (1.74% ahead of the fund's benchmark return and 3.91% ahead of cash benchmark returns).
A positive global environment with high risk appetite remained in place throughout the quarter which drove further search for yield and continued to provide a favourable backdrop for emerging market spreads and higher yield currencies such as the rand. The strengthening rand fuelled positive sentiment in the bond market resulting in the market becoming increasingly optimistic on the outlook for lower interest rates and inflation across the yield curve and allowing bond yields to continue to fall. The environment of low interest rates and falling bond yields was very positive for the property exposure in the fund which contributed to further capital gains in the portfolio.
The investment in corporate bonds within the portfolio has continued to perform strongly throughout the quarter, with the spread to government bonds of a number of the corporate bonds compressing quite substantially. This has been driven by the current low level of yields spurring significant investor appetite for yield enhancement. A number of corporate bonds are starting to reach expensive levels and we will continuously monitor these exposures and take further profit on counters when they become overvalued.
We remain of the view that nominal government bonds across the curve are very expensive, particularly at current levels, and provide increasingly unsatisfactory compensation for the risks that are starting to unfold from a macroeconomic perspective (with inflation bottoming, high money supply and consumer credit figures which will put further pressure on inflation, an increasingly vulnerable balance of payments situation and an expansionary fiscal framework). With US interest rates likely to increase further during the course of the year, global risk appetite is likely to start to wane at some point and should remove some of the support that has fuelled recent strength in emerging market currencies. We are very cautious of the bond market at current levels and are comfortable with the defensive structure of the fund which will be protected against the capital loss that will occur in the bond market as yields rise.
Although cash rates for a 12-month fixed term are low at 7.35%, the R153 yield can only afford to rise to 8.00% (ie, 18 pts) before it will start to underperform this cash rate. This is a very small margin given a situation where bond yields are priced for substantial good news, leaving them increasingly vulnerable to disappointment.
Although we agree that the inflation outlook has improved with the extended rand strength, we feel that the market is currently pricing in an inflation outlook that is too optimistic. One way to measure this is by analysing the difference between nominal (ie, fixed rate) bonds and inflation-linked bonds (which are linked to movements in inflation). The difference between these is known as breakeven inflation and is a good proxy for current market inflation expectations. Currently breakeven inflation for a bond maturing in three years time is approximately 3.75% - ie, only if inflation is lower than 3.75% over this term will nominal bonds outperform inflation-linked bonds. Although we think that inflation, based on our central forecast, is likely to remain within the 3% - 6% target band over this three year period, we currently project that the inflation rate will be closer to the upper end of the band by this time next year. We therefore feel that inflation-linked bonds are currently an attractive investment and have started to build a position in these bonds throughout the quarter. Inflation-linked bonds will also provide protection should inflation and interest rates surprise on the upside over the course of the year.
Given this backdrop, our strategy over the coming quarter is to remain defensively positioned to protect against capital loss should bond yields begin to rise off their current extremely low levels.