The fund returned a solid 3.14% for the quarter. September was a tough month for the domestic interest rate market. Aggressive foreign selling placed upward pressure on local bond yields, whilst the rand sold off sharply thus increasing volatility in the short term. For the quarter the All Bond Index (ALBI) gained 2.8%, just short of the 3% which was achieved by inflation-linked bonds (ILBs). These asset classes both outperformed cash - returning 1.4% - over the period. Over the past 12 months bonds and cash have performed in line with each other at 5.9%, while ILBs have been the star performer producing a 9.2% return. During the past quarter, foreign interest in buying South African bonds reached fever pitch levels particularly during August. This was driven mainly by declining yields on long dated bonds in the developed world. By the end of August, for the year to date, foreigners had bought close to R50 billion worth of SA bonds as the 'carry' pickup of between 5% to 6% was very attractive. However, this pickup did not come without risks. Foreigners were banking on a stable rand going forward, however the currency sold off by as much as 15% during September, effectively wiping out the carry pickup and more. This resulted in net losses for foreigners holding rand denominated government debt, with the response being a selling wave of bonds towards the end of the quarter totalling R14 billion.

The implications for inflation are concerning should the rand's weaker tone be sustained. We already expect that CPI will breach the SARB's target range of 3% - 6% by the fourth quarter of this year. The recent rand weakness will have a short-term impact, immediately resulting in higher fuel prices and with a lag in higher food prices. Most of the move will however feed through to next year's inflation data. Should the rand's current levels be sustained, and in the absence of any significant downward move in global commodity prices, the risk of a later and higher peak in CPI is very real. Should the rand/dollar exchange rate remain above R8.25, CPI is likely to rise to as high as 7%, with little prospect of returning to within target next year. Such an outlook is exacerbated by stubborn cost-push pressures from, for example, maize and wheat prices. Maize prices are up by almost 80% year on year, which will have an important impact on local CPI both directly and indirectly via the cost of animal feed. This implies that we will see high food inflation at least into early next year with the recent rand moves potentially prolonging this. On the fiscal front, the headwinds are also starting to gather momentum. Revenue collection appears to be lagging and the deficit is likely to be wider than budgeted. All eyes will be on the Medium Term Budget Policy Statement towards the end of October for an update on the country's latest fiscal situation. Implications for the bond market are that supply/issuance of government bonds could increase to cover this shortfall. Heightened interest rate volatility this quarter provided us with an opportunity to capture some of the best of the yield curve's fixed and floating rate offerings. Further to this we participated in the Standard Bank 7-year bond, thus locking in a spread above JIBAR of 1.50% for this term. Credit spreads have in recent months tightened significantly as investors desperately seek yield in a very low interest rate market. Conversely, offshore credit spreads have widened significantly during this time given European sovereign and bank worries, some of which are starting to filter through to SA however in a small way. After a few months of disappointing performance, preference shares delivered a better return of around 1.87% in September. Preference shares offer investors a much better yield than cash - currently the clean dividend yield on preference shares ranges between 6.7% - 7.4%. Inflation-linked bonds have performed well during the year, benefitting from real yield compression and rising inflation. However, we do still expect that there is more to come in the form of higher inflation which will add to the total return of these instruments over time.

The fund has remained fully invested during the quarter as real returns from cash and bonds are likely to be relatively poor over the next couple of years and this asset class provides a real return upfront - a rare prospect, we believe, going forward. The SA listed property index achieved a decent return for the quarter of 2.19% despite finding itself in the midst of interest rate and equity volatility. We took advantage of price movements to add to the property holdings at favourable prices. The offshore component of the fund has become an important focus given the need to diversify away from the overvalued rand. We have identified growing opportunities offshore in familiar names (Old Mutual plc, Investec Bank plc, Anglo American plc) at foreign currency referenced yields which are substantially better than what we are being paid domestically. The portfolio continues to be managed with the view of providing investors with a return which exceeds cash over time, without taking undue risk to achieve this. Opportunities in this low interest rate environment are less forthcoming; however, we continue to seek out the best relative value across the fixed interest space for our investors.

Portfolio managers
Mark le Roux and Tania Miglietta Client

The fund's 10-year anniversary was celebrated on 1 July 2011. Not only has this fund grown to become our flagship fixed interest product, but with an annual return of 11.5% p.a. since inception, this investment vehicle has got off to a good start, earning investors on average 2.5% p.a. ahead of cash over this 10-year period.

For the quarter, the fund returned 2.8% and for the past 12 months 10.1%. Much of this positive performance can be attributed to the renewed strength in inflation-linked bonds as real yields compressed lower, and ongoing good returns from the SA and offshore corporate bond markets, which saw spread tightening, translated into capital gains.

Ongoing concerns around a potential Greek default, or ultimate rollover of debt, have become the main pivot point for the "risk on -risk off" trade in global financial markets. The worry regarding a default is the potential contagion spreading across the region to those countries that are 'too big to fail and too big to bail' such as Spain. The political leaders in the EU appear to be willing to bail Greece out, but the Greek population seem vehemently opposed to the conditions (austerity measures) on which a bailout is based.

During the quarter, the 10-year US Treasury rallied to yield less than 3% on softer economic outcomes in the US as well as demand for safe haven investments which pushed the Treasury bond lower. Despite the fiscal woes of a number of European countries, the ECB raised interest rates by 0.5% in April to 1.25% for the first time in three years and again in July by a further 0.25%, following an announcement in the last week of June of its 'strong vigilance' with respect to inflationary pressures.

Local bonds took their cue from US Treasuries, rallying by around 30 basis points during the quarter to take the R186 government bond (maturing in 2026) and the R157 (maturing in 2015) to a yield to maturity of 8.50% and 7.51% respectively. Foreign investors have once again returned to the SA bond market, being the main drivers behind the rally. Foreign investors bought approximately R13 billion worth of SA government bonds in June alone. With the rand/dollar exchange rate relatively stable during the quarter at around R/$6.80, and still no sign of US interest rate hikes, the carry trade (holding higher SA yields versus lower US yields) is still favoured by foreigners.

Local inflation data continued on its upward trend, with May CPI at 4.6%, now above the midpoint of the South African Reserve Bank's inflation target range. We expect that CPI will approach the upper end of the target range of 6% by the end of the year. With the repo rate currently at 5.50% and inflation heading for 6%, negative real short-term interest rates appear to be on the cards towards the end of the year. Against this backdrop, inflation-linked bonds (with real yields of between 2.50% to 3%) still appear to be an attractive alternative in the SA fixed interest space. We have increased our preference share exposure in selected names that we believe offer good value relative to cash yields.

Property stocks delivered a better performance this quarter with prices rising in line with the stronger bond market. Yields on property stocks remain attractively priced at between 8% - 10%.

The fund's offshore component has edged higher during the quarter to around 6% as we believe the local currency to be unsustainably overvalued. We increased the fund's holdings in Standard Bank and Investec offshore bonds, both of which are attractively priced in US dollar and pound sterling. We also took profits on those corporate bonds which in our view have become relatively expensive.

The portfolio continues to be conservatively managed with the view of providing investors with a return which exceeds cash over time and without taking undue risk.

Portfolio managers
Mark le Roux and Tania Miglietta Client

The fund had another pleasing quarter, returning 1.56% versus cash of 1.4% and the All Bond Index (ALBI) which posted a negative return of 1.6% as a result of weakness in the longer dated part of the yield curve. Inflation-linked bonds (ILB) returned 1.2%, driven by real return compression during the quarter.

The first three months of the year was marked by a series of market-shaking events, encompassing natural disasters, political crises and continued economic concerns in some areas. While the sovereign debt crisis in the European periphery was never far from the headlines, floods in Australia in January, political upheaval in the Middle East and North Africa throughout the quarter and the earthquake and tsunami that hit Japan in March all grabbed headlines and rattled markets. From a bond market perspective, there tended to be conflicting effects from these events: on the one hand bonds benefitted from a safe haven bid, but on the other hand the impact on already-tight food and oil markets saw inflation fears intensify.

SA bonds continued to follow the lead of US Treasuries. These benefitted from a safe haven bid, as well as large purchases by the Bank of Japan as it intervened in foreign exchange markets to try to prevent the yen from strengthening as it repatriated its offshore investments. Treasuries (and SA bonds) had weakened significantly late last year, but the flight-tosafety bid appears to have put a lid on weakness for now, and Treasuries essentially moved largely sideways over the first quarter. SA bonds were weaker over the quarter as a whole.

As mentioned previously, we have continued to see inflation pressure arising globally from higher food and fuel prices. These pressures are beginning to feed into SA inflation in a more concrete way. In South Africa, although the rand has remained remarkably strong (largely due to a weak dollar), there are still signs of import price pressure starting to come through and we continue to be concerned about the second-round effects of food and fuel prices, given relatively high wage increases and still low local interest rates. We expect that inflation will reach or breach the upper end of the 3% - 6% inflation target range later this year.

On the fiscal front, a better-than-expected revenue number for 2010/11 has led to a provisional downward adjustment in the Budget deficit to 5.0% of GDP (from an estimate of 5.3% at the time of the February Budget). However, this is still a large number, and bond supply into the market will remain relatively high as well.

We thus remain concerned about bond yields from both inflation and supply factors. These domestic concerns are further deepened by an expectation that US bond yields will continue to rise over the course of the year as growth and inflation expectations continue to rise and as the eventual end of quantitative easing and the zero interest rate policy draw nearer. Pressure on US bond yields will likely see global yields rising, including SA.

During the quarter the portfolio's preference share holding was pared back as we took profits at the better prices. Timing was good as the preference share market saw some weakness during March. Current yields on bank preference shares are between 6.7% - 7.3%, some 0.5% better than they were late last year.

We continue to hold onto the core corporate bond and inflation-linked bond holdings which were purchased at very attractive credit spreads and real yields respectively. Both these markets have seen significant yield compression, and contributed positively to the portfolio's return. The banks began the year with a good dose of new funding, collectively raising more than R7 billion in medium to longer dated senior bonds. We were participants in this issuance where pricing was attractive, choosing the 5 year fixed rate area of the yield curve. To further back our view that interest rates are attractive in this part of the curve, we entered into NCD purchases yielding approximately 9.10% for 5 years.

The FRA curve shifted markedly during the quarter. In January it was still pricing in one further potential interest rate cut, but during February the curve shifted upwards eliminating any potential for a cut. Instead, it began to factor in a higher probability that the first of the repo rate hikes would be in November. Money market rates at 5.2% - 6.3% out to a year are pricing only a 50bp interest rate hike which we believe to be insufficient given the risks of upward moving inflation.

The fund is in our view defensively positioned, with the emphasis being on yield generation and capital preservation should an unexpected sharp upward move in inflation transpire.

Portfolio managers
Mark le Roux and Tania Miglietta

The fund delivered a good performance for the past year with a return of 11.2%, comfortably outperforming the riskfree money market asset class which returned 6.6% over the same period. This we attribute to the disciplined process followed and our proven ability to identify the best riskadjusted long-term opportunities for our clients. During 2010, the riskier asset classes outperformed. Longer-dated bonds returned 15%, preference shares 13.6% and inflation-linked bonds 11%. Property stocks topped all the asset classes, returning an impressive 29.6%. Overall, it has been a good year for SA investments and a particularly good one for the fund.

During late November the South African Reserve Bank announced a further 0.5% repo rate cut, taking base rates to a new low of 5.5%. We are however concerned about a potential upward move in inflation this year and believe that ongoing interest rate cuts will further spur this on. We note that the last two CPI inflation readings have come in worsethan- expected (even though the absolute level is still low, at 3.6% in November), yet interest rates are still being reduced. Breakeven inflation derived from the shorter end of the inflation-linked curve (2013 and 2017 maturities) remains near the top of the target range at over 5.7%, indicating that the market is expecting inflation to average this figure over the next number of years.

We do not believe there is further scope for cutting interest rates.In fact, should any further repo rate cuts materialise, we would take that as another negative for the longer-term inflation outlook.

Inflation-linked bonds were fair performers over the course of 2010. This was predominantly driven by capital gains achieved as real yields declined. We continue to hold onto the fund's 17% exposure given the view that inflation protection is likely to materialise during 2011.

During the final quarter of 2010, the fund lightened exposure to property, by selling the holdings of Resilient and Growthpoint after strong share performances. We have also reduced the fund's holdings in preference shares on relative value factors. Bank preference shares are now yielding around 6.5% which still offer a premium over the money market, but the risk remains that should interest rates start to rise prices could come under pressure.

Corporate bonds had a very good year, as spreads tightened across the curve on ever improving confidence in credit and a falling risk free rate. Corporate bond issuance remained healthy during the quarter with MTN a steady issuer having reached R4 billion of issuance during 2010. A new entrant into the bond market, Growthpoint, issued a 4 year inaugural floating rate bond which was well received. The fund participated in both of these issues.

At this point in the interest rate cycle money market yields are at 30-year lows and in our view offer minimal value. Banks' funding spreads for 12 - 36 month instruments have also fallen dramatically during the course of the year taking out all the value in this asset class for now.

Looking forward, in this low interest rate environment we seek to achieve a steady long-term outperformance of cash. However, the current low level of interest rates needs to be taken into account with regards to return expectations.

Portfolio managers Mark le Roux and Tania Miglietta