Bonds showed a marginally positive return in September, with the All Bond Index (ALBI) returning 0.08% and a respectable 3.0% for the quarter. Although the shorter maturity spectrum outperformed in September, it underperformed the rest of the index during the quarter, with long-dated bonds and non-government bonds in particular the best performers during the period. The third quarter also saw bonds outperform both cash (1.9%) and inflation-linked bonds (1.4%). Year to date, however, bonds still show a negative return, lagging well behind both cash and inflation linkers.

The lacklustre performance of bonds in September was largely due to a weakening towards month-end, and this seems to have been largely influenced by the retracement in FRAs at the time (see chart below). These moves followed the South African Reserve Bank's decision to leave interest rates on hold at the September MPC meeting (following a surprise cut in August). Although unchanged rates had been consensus, it was clear that the markets were getting bullish on a possible rate cut and thus disappointed at the actual outcome.

Against that background, the bond market largely ignored what should have been positive factors on other fronts: during September the rand strengthened further, US bond yields fell and the Emerging Markets Bond Index spread contracted. Economic data remained mixed from a bond market perspective. While economic activity data remained weak there were some upside surprises and conversely, while inflation continued to fall, the rate of decline remains gradual and CPI is still above the target range. While the bond market does not seem to have taken much notice of the stronger rand, we would emphasise that should the currency stay around these levels for any length of time, it has the potential to positively (and significantly) influence inflation going forward. We have already had a 5% petrol price cut announced for October and a number of other categories - including food prices - will be positively affected by rand appreciation. Thus the risk is that inflation falls into target sooner than the market is currently expecting and that 2010 inflation is generally better than current market forecasts.

The biggest concern probably remains the huge amount of supply to come to the market. The budget deficit has widened sharply in the first five months of the fiscal year as revenues show the effects of recession and expenditure on investment projects is frontloaded in the fiscal year. While official numbers will be announced later this month in the Medium-Term Budget Policy Statement, it looks like the budget deficit for the current fiscal year will probably be well north of 7%. However, there was a tentative improvement in both revenue and expenditure in August after some terrible figures earlier in the fiscal year and the final outcome may well be better than what is implied by simply extrapolating the year-to-date numbers. Even so, the final number will still be large.

Weekly bond market funding has increased recently. It will need to rise further unless the fiscus manages to correct, or unless there is another offshore issue. Despite corporate issuers (mainly banks), the funding requirement from government and SOE remain huge.

During September we continued to increase the inflation-linked and floating rate bond exposure in the fund. We purchased certain assets yielding CPI +4% and Jibar +1.50% as these appear very attractive applying a longer-term view. During the month we also sold down the Liberty International position to zero, fortunately prior to the rights issue announcement which placed the share under a fair amount of pressure. Listed property holdings were also trimmed as certain stocks had run hard during the period.

Portfolio managers
Mark le Roux and Tania Miglietta

The All Bond Index (ALBI) gave up some ground in June, resulting in an anaemic return of 0.3% for the quarter. The shorter-dated area of the curve was the right area to be in, but that still underperformed cash (both in June and for the quarter as a whole). While inflation-linked bonds performed well throughout the period, they lagged cash in June. Year to date, inflation linkers have been the best performing asset class, followed by cash, with the ALBI lagging significantly behind.

A number of factors undermined local bond yields this year, and especially in the second quarter when yields failed to take much heart from, for example, a stronger rand. Also note that the lacklustre performance of bonds has happened despite the aggressive easing in short rates this year - the South African Reserve Bank (SARB) took just 6 months to unwind almost all of the tightening put in place over the two years from June 2006 to June 2008.

Firstly, consumer price inflation (CPI) surprised on the upside this year, remaining persistently high despite a fast declining producer inflation. While we may yet see some more rapid downward movement in CPI, owing to the recent stronger rand, many analysts have revised their forecasts higher and this has undermined bonds, but adds support to inflation-linked bonds.

A second factor undermining local bonds during the past quarter has been the rise in global bond yields. The US 10- year yield has risen from around 2.70% to 3.50%, threatening the 4% level at one point. As talk on the global stage has turned to recovery and with it exit strategies from the expansionary policies, including quantitative easing, global bond yields have risen. SA bonds often move in tandem with global ones and this time has been no exception.

Thirdly, as fiscal positions almost everywhere have suffered from the economic slowdown (i.e. declining tax revenues as well as spending pressures), concerns have mounted about the large increases in the supply of bonds required to fund fiscal deficits. South Africa has been no exception to this, and just past quarter-end Finance Minister Pravin Gordhan announced some details of the revenue shortfall to date - significantly worse than many in the market had anticipated. From an originally budgeted deficit of 3.8% of GDP announced in February, it now looks likely that the deficit will surpass 5% of GDP. Indeed, if trends do not improve from what we have seen so far in the fiscal year, it could even be in excess of 6%. While the exact intentions for funding this deficit remain unclear at present, what is clear is that the domestic bond market will not escape unscathed.

Finally, despite our earlier mention of the rapid unwind of last year's rate increases, note that the SARB paused its easing cycle in June against market expectations of a further 50bp repo rate cut. While this is positive for the bond market in the longer term (as it supports the longer-term inflation outlook), in the short term it acted to brake potential gains in domestic bonds.

The near-term outlook for bonds remains murky. On the one hand, a positive argument can be made from the likely trends in CPI and the fact that the market may well have underestimated the effect of a stronger rand on pulling inflation rates down from current levels. But on the other hand, concerns about supply pressure will remain and may well weigh the market down for a while, especially while the exact composition of the revised funding requirement remains unknown.

Money market rates have fallen dramatically this year, but retraced by a percent in the 1-year area following the SARB's announcement in June to halt its interest rate cutting cycle. Both Treasury Bill and corporate paper issuance have increased this year, taking substantial market share from the banks. This is starting to put some upward pressure on NCD rates. We took the opportunity to switch out of a few select corporate bonds and medium-dated RSA bonds just prior to the interest rate announcement and switched the proceeds into the 1-year NCD at its higher levels. We recently introduced a holding in the R153 government bond, now having retraced from its lows of less than 5% to over 7% yield to maturity; this, in keeping with the fund's benchmark exposure to the bond.

Preference shares, returning 12% for the year, performed very well in response to a rapidly declining interest rate environment. As expected, this good performance did slow during the past quarter given the likelihood that interest rates have bottomed for now. Although dividend distributions from preference shares are now lower as they are linked to the prime rate (currently at 11%), these distributions are likely to continue paying handsomely throughout the cycle as declining company earnings are putting pressure on dividends from ordinary shares. Preference shares are yielding between 8.5% and 10.5%, depending on the credit quality of the issuer. Although coupled with added risks, these yields are still higher than those available in the money market.

Corporate bonds, which include parastatals, are showing very attractive yields given new issuance (greater supply) in the market at ever-widening credit spreads. Issuers have been looking for funding via this market due to bank funding becoming more challenging. Consequently, these bonds have been lapped up by funds seeking higher yields over the medium to longer term. We participated in the Standard Bank and ABSA senior bond issues priced at 260bp over the RSA bond equivalents, which we believe are very attractive yields for funding ranking pari passu with bank deposits.

Property stocks have remained very volatile this year and may come under some pressure should interest rates not decline further. We have reduced our holding via one share in particular due to the expected lower distribution. This brings our overall property exposure down to 5.4%. We also remain concerned about the possible effect of a bottoming interest rate cycle on the property sector over the shorter term. We have kept a small strategic holding in the fund as the expected return over three years continues to be north of 20%.

The fund continues to weather the storm of volatile markets in a challenging macro-economic environment by staying on the conservative side and choosing entry and exit points into the riskier assets in a measured way.

Portfolio managers
Mark le Roux and Tania Miglietta Client

Despite two consecutive higher-than-expected inflation releases in the first two months of this year, expectations of rate cuts intensified heading into 2009. This occurred as local and global economic indicators continued to show significant weakness coupled with developed country central banks increasing their pace of monetary easing via both interest rates and direct liquidity injections.

Against that background, SA money market rates continued their steady fall as prospects for lower interest rates became more likely. The Reserve Bank surprised the market with its call to meet monthly rather than bi-monthly, which signalled that the bank would accelerate repo rate cuts, although Governor Tito Mboweni subsequently said that the MPC would not feel compelled to cut rates at every meeting. On 24 March, at the first of the monthly meetings, the Governor announced a 1% repo rate cut, equalling the February cut and in line with expectations. This resulted in 2.5% in interest rate cuts so far in this easing cycle, bringing the repo rate to 9.5%. The FRA market has been pricing in a quick succession of interest rate cuts, expecting the market to bottom out with the repo rate as low as 6.5% at one point. This has since been tempered somewhat, with a low of 7% now expected.

The NCD market traded below 8% for a one-year NCD, but quickly retraced to close the month at 8.30%. The market has rallied hard from its high of 14% in mid-2008, and considering that it was still above 13% as recently as October 2008.

The bond market lost just over 5% in the first quarter, with the losses realised in January and February before the All Bond index (ALBI) stabilized in March. There has been a significant difference in performance across maturity bands, however. For the quarter, short-dated bonds returned +2.3% while the longest dated bonds (12 years and more) lost 10.8%. The short end was supported by a 200bp reduction in the repo rate year-to-date, coupled with expectations of further aggressive easing. Meanwhile, the long end underperformed due to higher-than-expected inflation data and probably some concerns about the large amount of supply due to hit the market, as well as a retracement in global bonds.

With regards to local fundamentals, there are conflicting influences on bonds. We are in a situation where the growth outlook has been continually downgraded and while opinions vary on its extent, a recession has now become the consensus forecast. As an offset, however, the inflation outlook - which briefly looked very promising late last year - has taken a turn for the worse. Both January and February CPI numbers (released in February and March) surprised the market on the upside, and the oil price appears to have arrested its decline.

Furthermore, funding pressures from the budget deficit - as well as funding for the parastatals' investment programme - is set to add significantly to supply of bonds.

In the shorter term we believe that bonds may remain overvalued as the market continues to focus on slow growth and further repo rate reductions. In our view the bond market is fundamentally expensive and we hold no government bonds in the Strategic income unit trust.

Also on the negative side during the quarter, corporate spreads have widened somewhat, reflecting the markets over saturation of corporate debt and the increased risk prevailing in the market at the moment. We do however see this spread widening as a very good buying opportunity for fixed income funds.

The Coronation Strategic Income Fund holds around 54% in money market assets, with another 4% in floating rate corporate bonds. These act as an interest rate volatility buffer and have provided the fund with much needed protection during recent months. These assets also contribute to the overall yield of the fund as they are largely linked to JIBAR with a generous spread.

A new entry into this fund is a holding (4%) in corporate Inflation linked bonds which were bought at a real yield of between 5.5% and 6% and will provide inflation protection going forward. Given market pricing on inflation linked bonds relative to nominal bonds, we believe that the better value lies in the inflation linked market.

The fund has a duration of 1.08 which is shorter than that of its benchmark, the 1 - 3 year Bond Index (1.25), which given the nature of the funds mandate to provide yield and capital protection where possible, we deem it prudent.

Holdings in listed property (6.2%) and listed preference shares (7.3%) remained relatively constant and we expect these asset classes to start delivering decent returns relative to cash with the acceleration of the interest rate down cycle.

Bonds were the best performing asset class during 2008, returning an impressive 17% for the year despite a very bearish start brought about by a surge in inflation and sharply rising interest rates. Bonds looked set to produce negative returns for most of the year until July, when bond returns turned positive as the oil price started to fall and Statistics SA indicated that the CPIX index would be reweighted and rebased in January 2009. Calculations showed that inflation was indeed going to fall sharply. However, this has taken some time to materialise and only in November 2008 did we see the first convincing decline in inflation. By December, CPIX was at 12.1% - still high, but moving lower. Bond yields peaked in the 3rd quarter, falling sharply thereafter in anticipation of an imminent downward turn in the interest rate cycle. Bond market returns improved dramatically during the 4th quarter, supported by domestic investors piling in after months of being short duration. On the 11th of December SA Reserve Bank Governor Tito Mboweni announced the first 0.5% cut in the interest rate cycle, taking the repo rate to 11.5% after 10 consecutive hikes starting in June 2006. During December, bonds touched 7% before ending the year slightly higher at 7.21%. The market is pricing in a very bullish outcome for short-term interest rates over the next year and is expecting as much as a 1% rate cut in February, with further cuts thereafter. The fund was well positioned for this sharp turnaround in the bond market, with us having extended its duration during the latter part of the year. Corporate bonds, representing 23% of the fund, contributed to the stronger performance. The fund's 50% holding in both floating and fixed-rate money market NCDs are the income generators of the portfolio. These instruments, still paying interest in excess of 12% p.a., provide the fund with the required income for investors. Money market rates, now much lower, are pricing in all of the expected interest rate cuts, and no longer offer the same excellent value that they did during 2008. Listed property made an impressive recovery during the second half of 2008, with the listed property index achieving a whopping 33% for the last six months after a dismal first half of the year. This rerating took place in line with the bond market recovery and was backed by ongoing good distribution growth which supported share prices. Preference shares, still offering good non-taxable yields of around 12% for the bank-issued names, represented 7% of the fund by year end. Prices have been very depressed in this sector, and liquidity low. However, with a non-taxable yield in excess of money market rates, it remains an attractive investment. History shows that the prices respond to changes in the interest rate cycle, and we expect that some price recovery should come through as interest rates are reduced. After a particularly tough first six months, the fund rebounded strongly with a return of 9.7% for the year - with the majority of the return coming in during the last six months. The fund continues to be conservatively managed with the focus on income generation, and looking for opportunities to generate capital returns from assets where the risk/return trade-off is in our favour.

Mark le Roux and Tania Miglietta
Portfolio Managers