The bond market staged a rally in September, helping to lift the All-Bond Index (ALBI) to a 3.4% return for the third quarter. This was one of the few times over the past year where bonds have outperformed both cash and inflation-linked bonds. The 1 -3 year Bond Index returned 2.7% for the quarter, however significant weakness in the bond market in the May-August period is still depressing longer-term returns.

The SA Reserve Bank raised the repo rate another 50 basis points in August, bringing it to 10%. While concerns around inflation lingered with a string of worse-than-expected data releases, sentiment started turning after international factors took the lead role. As concerns about the sub-prime fall-out's impact on financial markets spread - the market started to price in a US rate cut. The Federal Reserve duly delivered, even surprising the markets with a 50 basis points cut at its September 18 Federal Open Market Committee (FOMC) meeting (most analysts had expected 25 basis points).

The Fed's move reignited interest in risky assets, with SA bonds joining a general emerging markets rally. The dollar has also come under pressure recently, and the rand has benefited handsomely from this, once again breaking through the R/$7 level. Given the importance of the rand to SA's inflation outlook, and against a background of near-record highs in global food and energy prices, the currency move is a welcome respite.

SA's current inflation situation remains an uncomfortable one. CPIX has been above the upper limit of its 3% - 6% target range since April, and will probably be there until March 2008: representing a full year above the target range. While much of this impetus has been driven by higher food prices and last year's rand fall, the SARB remains concerned about credibility. On a longer-term view, however, the big picture is rosier. Even with the lags involved, it is already clear that consumer spending and consumer credit cycles have turned as the effects of past rate rises start to bite. At the time of writing the October MPC has yet to take place; while it will be a close call, we think there are solid arguments for leaving rates unchanged. If they do rise again, it should clearly be the peak in the cycle. On the current outlook, we see scope for the repo rate to start falling in the second half of 2008.

We increased the government bond holding in the fund on bond weakness as signs of the top of the interest rate cycle emerged. We also participated in the recent Nedbank corporate bond at a very attractive credit spread of 1.85% above RSA government bonds.

Money market interest rates have stayed well above 10%, but the close to 11% seen in the 3-year term has now been priced out on the recent bond rally. The fund has a 45% holding in low risk high yielding money market NCDs.

International money markets reached crisis levels in both the US and Europe this quarter, with sub-prime loans hitting the short term securitisation markets (asset backed commercial paper - ABCP) severely, and drying up issuance thereof. The lack of liquidity has been a big issue in international money markets to which in some cases, banks have had to provide emergency liquidity. In SA we were somewhat shielded from the international money market volatility as SA banks are not exposed to the very risky securitisations which caused the credit crunch and default worries.

The fund has not participated in SA-listed securitisation in recent years, since pricing never fully compensated us for the lack of liquidity (ability to sell) or the credit risk that these investments represent. The pricing has since improved significantly in the form of widening credit spreads.

Liberty International plc displayed extreme volatility this quarter, starting the period at a price of R160 trading to a low of R148 then a high of R173. It closed the quarter at R157, close to its starting price, but after considerable intra-month swings. We reduced our holding in Liberty International plc to protect investors from unnecessary volatility. We continue to hold 1.5% in this share as we believe that it is still attractive with good diversification and rand hedge properties.

Domestic property holdings in the fund remained steady, although note that price volatility has increased. We have sought to top up on favoured property counters on price weakness. Volumes have been very thin however as liquidity tends to dry up during very volatile times.

Preference shares currently provide a non-taxable yield of between 10% and 11%. Price weakness has dogged this sector since the second quarter, but prices should start to turn once the top of the interest rate cycle is in view. Preference shares offer very good value to investors.

The Coronation Strategic Income Fund which is currently yielding around 9.6%, returned 2.5% for the quarter.

Mark le Roux and Tania Miglietta
Porftolio Managers

June was not a good month for bonds and other interest rate sensitive investments. A general sell-off took place as inflation and interest rate worries filtered through. The 1 - 3 year bond index, returned 0.7% for the quarter, underperforming cash.

During the quarter the interest rate picture took a turn for the worse as inflation data exceeded expectations. In response to CPIX breaching the 6% upper end of the target range the SARB raised the repo rate another 50bp in June (having been on hold at the February and April meetings). Pipeline pressure continues to be evident in PPI, and CPIX is expected to remain above 6% for most of the next three quarters. This, and the potential effect of higher inflation on inflation expectations, means it is likely that the SARB (also with an eye on its credibility) will raise rates again at the August MPC.

However, it is noteworthy that while consumer demand data are generally still strong, there are clear signs of the peak having passed. Car sales are slumping, while other spending and consumer credit are starting to slow, hit by a perfect storm of higher rates, higher prices and (in June) the introduction of the National Credit Act. A consumer slowdown will help ease concerns both over the current account deficit and inflation further down the line, while the latter will also be helped by the recently stronger rand. Thus, if the SARB does raise rates in August, there is a good chance that would be the end of the cycle.

1 - 3 year money market investments continue to provide very attractive yields of well over 10%. The market has been very bearish, pricing in up to two more interest rate hikes of 50bp each.

The bond market sell-off that ensued this past month provided us renewed opportunity to buy more bonds.

Property stocks came under pressure as the bond market sold off. These are very interest rate sensitive investments and will respond to fluctuations in the interest rate cycle. We continue to hold those shares which we believe are likely to outperform cash over a three-year horizon.

Preference shares have continued to deliver good yields, currently providing over 9.4% yield, which is non-taxable. Prices are likely to respond positively when the peak of the interest rate cycle is within our sights. Preference share volumes have also been increasing as certain banks are actively issuing more shares to the market on an ongoing basis. This should lessen their problematic illiquidity.

Liberty International plc was introduced to the fund this quarter but has not yet delivered the performance that we would like. The stock is showing better value than a year ago and over the longer term should provide investors with good returns.

The Coronation Strategic Income Fund continues to look for pockets of opportunities to enhance returns at the right price and strives to minimise downside risk where possible. The fund returned 0.80% for the quarter, somewhat disappointing given its sterling performance to date, but still outperforming the index.

Mark le Roux and Tania Miglietta
Portfolio Managers

The Coronation Strategic Income Fund achieved a return of 3.18% for the first quarter, compared to its benchmark of 2.17%.

We enjoyed a bullish start to the year with the R157 (2015 RSA bond) opening with a yield to maturity of 7.73% and trading to a low of 7.5% by late February. This was driven by the dovish stance taken at the February MPC where the committee's decision was to leave the repo rate unchanged at 9%. By then the inflation outlook had improved, the committee highlighted that credit extension although still high, had become more corporate driven. It therefore meant that consumer borrowing was not as rife as previously recorded and since corporate borrowing is healthier for the economy than is consumer borrowing (since more investment and development is taking place). This and other important factors gave the SARB reason to leave interest rates unchanged.

Around six weeks later, the landscape started to change however, with higher oil prices, a weaker rand and later, higher maize prices creeping in. These all pose greater risks to future inflation. None of these prices have yet subsided, and effective early April, a large petrol price hike of around 68c per litre was imposed. So the risks to higher inflation remain.

In response to the changed landscape, although with a bit of a delay, the bond market sold off giving back most of its gains. The R157 closed the quarter just higher than its opening level at a yield to maturity of 7.82%. The All Bond Index (ALBI) returned 1.6% during the quarter, which is less than cash achieved (2.04%). Within the bond sectors, the 1-3 year index was the best performer for the quarter (+2.1%) and the 12+ year index, the worst performer (-1.07%). Inflation linked bonds only returned 1% during this time. The 12-month return from bonds at 5.6% has still been dismal compared to cash at 7.81%.

On that note, money market yields have been more volatile than usual, mostly in response to the weaker rand and the other inflation risks. The FRA curve, which acts as the market barometer for short term interest rate expectations, is now pricing in around a 35% - 45% chance of another repo rate hike either in April or June. One-year money market yields are as high as 9.70%, up from previous weeks. The large SA banks seeking more funding to provide for their ever growing loan book are increasingly willing to pay up for long-term deposits. 18- month and 2-year money market interest rates are now paying 9.60% pa. This is certainly a better return (and lower risk) than expected bond returns for the next year.

The Strategic Income Fund has remained conservatively positioned with an overweight cash position (earning the yields mentioned above), a very low exposure to government bonds and a moderate corporate bond holding.

During the quarter a number of new corporate bonds and securitisations were brought to market. In most cases, we felt that the pricing wasn't attractive enough for the risks assumed and so did not participate. However, we did introduce the AB07 (ABSA, 2014 maturity) into the fund as this AAA-rated bond was issued at a yield to maturity as high as 1.2% over the equivalent RSA bond. We also participated in the ACSA bond (Airports Company of SA, 2019 maturity) at an attractive spread. Such spreads on good quality bonds have not been around for more than a year now.

We note that the corporate bond market has become more of a buyer's market as issuance has increased dramatically (as companies and banks seek cheap funding). Supply now exceeds demand and the pricing reflects this. Credit spreads on many of the corporate bonds, especially the bank bonds, have widened substantially since issue. Eg Nedbank 2018 was issued at 0.64% over the R201 and is now trading at 1.22% resulting in some capital loss to the investor.

Preference shares had a nasty month in February, with prices falling sharply on the back of the announcement that STC (secondary tax on companies) would be phased out and replaced with a tax on dividends. There was much uncertainty about the impact this would have on preference shares, which are largely held for their high tax exempt dividend yield. Issuers were quick to confirm however, that all tax benefits received by the issuer would be passed on in full to the investor, thereby having a neutral effect. Our view is that at these price lows, with preference shares yielding between 9.3% - 10.7%, this presents a very attractive buying opportunity. We have upped our weighting in preference shares, which will reflect in the portfolio in April, on settlement.

The fund's property holdings have delivered good returns for investors this quarter however we have been trimming back on selected holdings, reducing risk where prices have approached fair value. Yields have fallen in this sector as a result of higher prices, and where the expected 3-year return is still attractive, we continue to hold the stock.
The fund continues to produce pleasing returns, largely gained from the fixed interest sectors which traditional bond and income funds do not participate in, thereby confirming that a more flexible approach to fixed interest money management pays better dividends (and interest!) over time.

Mark le Roux and Tania Miglietta
Portfolio Managers

At the close of the year we saw bonds record new lows of 8.01% (R157, 2015). Given where bond yields were in September 2006 (8.90%), the market corrected substantially, taking bonds back down to what we term fair value. In recent months, rising short-term interest rates dominated the fixed interest market causing the yield curve to rise, especially short-term interest rates and volatility. This resulted in poor bond performance for much of that time, but some of this has since reversed. Inflation worries are subsiding given that the repo rate was hiked four times from June to December 2006. The bond market views this positively and subsequently traded better towards the end of the year. For 2006 the All Bond Index achieved a return of 5.5%.

The Coronation Strategic Income Fund is designed to avoid the downturns in the fixed interest market, and subsequently achieved a very pleasing total return for the year of 10.4%, comfortably beating the benchmark which did 5.7%. The fund continues to successfully achieve its objectives of high yield with some capital protection. Due to good timing on the overall bonds, careful selection of corporate bonds and a buoyant listed property market, the fund was able to achieve better than normal capital gains for investors this year.

The bond market's most recent rally in December was fuelled by the better than expected November CPIX and PPI figures. CPIX came out at 5.0%, unchanged from October and below forecasts of 5.4%, while PPI was 10% year on year, also better than expected. Part of the reason for the lower than expected figures was a muted increase in fresh food prices, which is an important component of the inflation measure. The oil price remained flat for the year and the currency, although depreciating at one point turned around and made back some of its losses. These two factors, as we've noted before, are important for the direction of inflation.

Money market interest rates rose on the news that the South African Reserve Bank hiked the repo rate to 9%. However, looking forward, the market is no longer expecting interest rates to continue rising, instead, it sees a possible pause in the interest rate hiking cycle and possibly a repo rate cut within 18 months to 2 years. In the portfolio, bond and property holdings were increased during the month. Bonds via the re-entry into the government bond market and property via selected undervalued stocks. We also switched within the property sector as some strong price rises led us to take profits, investing the proceeds into those that still offered better value. The property holdings have contributed positively to fund performance over the last few months. Similarly, our re-entry into the bond market in September at the higher levels noted above, has paid off.

It's been a good year for the Coronation Strategic Income Fund which has now grown to over R3.5 billion in size, and we thank all our investors for supporting us during 2006 and look forward to an exciting and rewarding 2007.

Mark le Roux and Tania Miglietta
Portfolio Managers