The fund returned 1.03% in October, bringing the rolling 12- month return to 11.46%, which is still a healthy margin over cash. We urge investors however, to not expect similar outperformance of cash going forward as the risk/return profile of investments is continuously changing to reflect higher risk for the same or lesser return. The All Bond Index (ALBI) lost 0.6% in October, with sharply differing performances depending on maturity; shorter dated bonds managed a small gain, while the 12+ maturity bucket lost over 2% during the month. Cash returned 0.44%, while the star in the fixed income space was again inflation-linked bonds (ILBs), returning 1.37% over the month. For the past year, ILBs have returned just short of 20%, versus 13.2% on the ALBI and 5.68% on cash. SA was included in the Citigroup World Government Bond Index (WGBI) as at the end of September. In a pattern that had been seen in other markets, SA bonds weakened post the WGBI inclusion, despite the fact that foreigners continued to be net buyers of bonds (albeit at reduced levels compared to the previous few months). While the foreign inflow slowed, a number of SA-specific factors turned more negative for the bond market. The rand weakened sharply in October, averaging R/$8.65 (from 8.26 in September), and reaching a worst level just short of 9/$ during the month. The currency weakness was specific to SA, and appears to have been caused mainly by a combination of negative sentiment around prolonged and violent strike activity and the news that SA recorded a current account deficit of some 6.4% of GDP in the second quarter - with the strikes in the mining sector likely to continue to have a damaging effect on exports. Trade balance data in the third quarter continued to show a very weak outcome - the January-September deficit already exceeds the previous worst full-year record deficit - and implies that the current account will continue to impart vulnerability to the rand. There was also bad news from the ratings agencies. Moody's downgraded SA's credit rating from A3 to Baa1 near the end of September, and retained a negative outlook. This was shortly followed by S&P downgrading the sovereign from BBB+ to BBB, also retaining a negative outlook. Fitch is expected to review its rating early next year, and we would expect it to join the other agencies in a downgrade. Note that BBB- (S&P and Fitch) and Baa3 (Moody's) - one notch down from the current S&P rating and two notches down for the others - is the lowest rung of investment grade. The inflation picture also turned less rosy for bonds. September consumer inflation surprised to the upside, with CPI lifting to 5.5% (from a recent low of 4.9% in July). The turn was driven as the earlier positive effects of food and petrol disinflation dissipated, with these factors starting to put upward pressure on inflation once again. We also discern creeping evidence of the weaker rand - recall it was already weaker earlier in 2012 versus its 2011 levels, even before the recent move - in the data. Continued pressure on food prices and the effects of the weaker rand are in our opinion likely to continue to lead inflation higher, and we expect another breach of the target on the upside next year. The Medium-Term Budget Policy Statement (MTBPS) was released towards the end of October, and as expected showed wider expected budget deficits on the back of a slower growth outlook (though we would also highlight deterioration in the composition of spending due to the higher wage settlements). The current fiscal year deficit is now budgeted at 4.8% of GDP, and is expected to narrow to 3.1% of GDP by 2015/16. Bond market funding requirements have also been revised higher to R136 billion for the current fiscal year. With the large funding requirement, the participation of foreigners in the market remains crucial to preventing a significant sell-off in yields. Local bonds are still finding support from low global yields and the associated continued inflow into higher-yielding bond markets, including South Africa. While this flow of funds will probably continue to broadly support the market, ongoing negative domestic news will continue to affect our market. The short end remains anchored by SARB policy, where although the market is currently pricing in a low probability of a further rate cut, it is unlikely that we will see rates increase for quite a long time. This leaves the long end to take the brunt of inflation, rand and fiscal concerns, and implies that the curve will remain steep, with a weaker bias, over the medium term. With this in our sights, we continue to run an overall fund duration of less than 1, with the focus on capital protection and yield generation. We have increased holdings in floating rate instruments (with a 4-year term) and added to the fund's offshore exposure as the currency moves have allowed. The fund generates a great deal of interest which is reinvested and thus compounded on an ongoing basis, we do however note that with spreads tightening, and yields low, new opportunities are not as appealing as in months gone by. Corporate bond issuance has slowed in October, with the banks being the only sizeable issuers in the market. Standard Bank issued a 2020 maturity bond shortly after an aggressive sell off in the long end of the curve. Due to the relative value offered, we decided to invest new cash in this Standard Bank issue. We have been trimming back property stocks that seem overvalued as ongoing price appreciation calls for some profit taking in certain areas. At the same time however, we have added to some of our holdings where we see value confirming that this is an actively managed fund where we continuously looks to enhance yield and manage capital risk. Inflation linkers, though relatively expensive to historic pricing, are still a worthwhile investment and thus we continue to hold onto them, and look for buying opportunities. The fund has benefited enormously from this asset class which has delivered capital gains as real yields have compressed, and as we see inflation starting to rise, will now deliver inflation protection by design. This asset class has been a very good long-term holding for the fund. We continue to position the fund in a conservative way focusing on protecting capital, taking profits where deemed appropriate, and seeking to maximise yield in a challenging market where yields are at all-time lows.
Portfolio managers
Mark le Roux and Tania Miglietta

The fund returned 3.13% for the quarter, contributing positively to its ongoing good one-year rolling performance, which now totals 11.3% for the last 12-month period to end-June. A strong performance by the South African nominal bond market in the second quarter contributed to the fund return as bonds convincingly outperformed inflation linkers (ILBs) and cash over the quarter, as well as over the last 12 months. The All Bond Index (ALBI) returned an impressive 14.6% over the past 12 months, significantly ahead of both inflation (year-onyear CPI of 5.7%) and cash (5.8%). ILBs also delivered a strong return of 12.3% for the one-year period. The benchmark nominal government bond, the R186 (2026) rallied close to 50 basis points during the quarter. Global risk aversion and the deepening crisis in Euroland continued to take centre stage, both locally and globally. The flight to safety was reflected in record low yields reached in core markets such as the US and Germany, while spreads on more risky assets widened. Although core yields ended the quarter off their lows reached in early June, they still gained from already low levels. By contrast, yields in countries at the centre of the Euro crisis rose over the quarter. The Greek elections were a key feature during the three-month period, but attention started to shift to the larger economies of Italy and Spain. Bond yields rose in both these countries over the period, especially in Spain on growing concerns over its banking sector. By late June, there was open talk of a bailout. Globally, other risk assets also lost ground on a combination of growing Eurozone concerns, weakness in global growth indicators and some disappointment about the extent of stimulus provided by the major central banks. Included in this group was the rand, which depreciated from R/$7.66 at end- March to R/$8.14 by end-June. Despite the weaker rand, SA bonds gained over the quarter, largely taking lead from the downward trend in US bond yields. The yield curve steepened over the quarter as the short end of the curve followed the FRA market, which started to price in a 50% odd probability of a rate cut. This was in response to the change in stance by the Monetary Policy Committee (MPC) in their May statement from previously indicating that the next repo move would probably be upwards to now being ready to move 'in either direction' as circumstances warrant. The market has interpreted this (probably correctly) as meaning that the MPC is currently more concerned about the fallout from Europe than current SA inflation. An improved short-term inflation outlook also provided support to the bond market. CPI generally came in below expectations during the quarter, largely due to stronger food disinflation than anticipated, while the sharp drop of 19% in the price of oil (Brent crude) since the beginning of the quarter will exert significant nearterm downward pressure on CPI. While CPI will probably fall to around 5% in July as a result, the medium-term outlook is less comforting, as the effects of the weaker rand this year start feeding into the numbers. There is also some concern that global food prices may be bottoming. Although we now see CPI within the target range for the rest of this year, we expect - in the absence of further sharp declines in the price of oil - for it to turn higher and breach 6% again next year. Given the improved short-term inflation outlook and increased demand for South African bonds due to its expected inclusion in the Citi World Government Bond Index, we identified an opportunity to increase our exposure to the bond market, mainly investing in higher quality credit issues. Banks were once again present in the bond market with sizeable issuance ranging between three to fourteen year terms. SA non-bank corporate bond issuance has been slower this year despite a number of maturities, indicating that many do not require the funding. Instead newcomers to the market from the property sector have been issuing new bonds and commercial paper. We have seen some credit spread widening in the longer-term money market floating rate notes (as issued by the banks) out to five years term to maturity as they seek longer dated funding. Banks will continue to require long-term funding as they prepare to start meeting the Basel III requirements, which will be phased in from January 2013. We have indentified value in this market relative to what is available in the equivalent term corporate bond space, much of which is looking expensive. We have indentified value in this market relative to what is available in the equivalent term corporate bond space, much of which is looking expensive. Expectations for lower inflation and now lower interest rates for longer in the domestic market provided further support to listed property. Another boost to the sector was a renewed focus on potential corporate action as both Redefine and Capital Properties announced the potential acquisition of Fountainhead and SA Corporate respectively. We may see some potential bid premia starting to be priced into other stocks where the market views them as potential take-over targets. All of these pushed the sector to delivering an impressive total return of 10.3% for the quarter. The fund has provided very good returns for investors over its now relatively long track record. The challenge remains in identifying instruments that provide the correct balance of risk and return for our investors.

Portfolio managers
Mark le Roux and Tania Miglietta

The fund returned 2.04% for the quarter and has maintained a pleasing 11.0% total return for the last 12 months, comfortably outperforming cash by a margin of 5.5% over this period.

The All Bond Index returned 2.4% for the quarter, most of which was achieved in January. The Inflation-linked Bond (ILB) Index outperformed nominal bonds as CPI remained above the target range. ILBs therefore remain the bestperforming fixed interest class over all time periods. Cash, which is yielding around 5.5%, has significantly underperformed other yielding assets during the quarter and over the last year. Note that the real return on cash has barely been positive over the past 12 months, and on a forwardlooking basis out to one year, current cash rates are expected to show negative real returns.

Despite a plethora of global and local market news, bond yields were largely unchanged at the end of the three-month period compared to end-2011 as the rally in January was largely reversed during February and March. A more convincing downward move was seen in ILBs in general, particularly in the shorter-dated R189 where its real yield moved deeper into negative territory. It closed the quarter at -0.5% on a combination of higher inflation and potential buybacks of the bond ahead of its maturity in March 2013. On the global side, concerns about the Euro area have ebbed somewhat as a restructuring agreement on Greek debt was reached. This resulted in an effective 'voluntary' haircut of around 75%.
Despite the markets clearly showing relief, Greece is however still not out of the woods as the new 10-year bonds are already trading over 20%, indicating continued scepticism; and a third bail-out package is already being talked about. Meanwhile, concerns about Portugal remain, worries over Spain are increasing, and Ireland is to hold a referendum on the fiscal treaty on 31 May. Thus, while concerns about Euroland have receded for now, the potential for further upset from this angle is clear.

US bonds sold off somewhat over the quarter on the reduction in risk aversion combined with some stronger-thanexpected data. The US 10-year ended March at 2.21% compared to 1.88% at end-December. SA bonds broadly tracked trends in the US, albeit finishing the quarter on a slightly stronger note. Locally, a focus was the annual budget speech in February. This surprised markets on the positive side, with the Minister reigning in the deficit projections. It has since been announced that the expected deficit for the fiscal year just ended (2011/12) is 4.5%, slightly better than expected at the time of the budget. Funding requirements still remain high, and there is some scepticism over the extent to which public sector wage increases can be reigned in - this being an important contribution to the expected lower deficit numbers. Soon after the budget and despite the improved numbers, Standard & Poor's joined Moody's and Fitch in attaching a negative outlook to its credit rating on South Africa. These agencies cited structural problems and the potential for politics to put pressure on the budget sometime in the future. On the monetary policy side, although there is clearly no desire to raise interest rates anytime soon, the SARB has started expressing its concern about more broad-based inflation. We continue to see inflation remaining above target through the first half of next year. The rand could be a game-changer, but continued passthrough from oil and food price hikes as well as the increasing likelihood of further second-round effects from petrol prices (with the Gauteng pump price nudging R12/l) keeps us cautious. We continue to believe that with inflation above target and growth at around 3%, a negative real repo rate is too accommodative and we expect interest rates to start being normalised later this year.

The fund has maintained its high proportion to medium dated money market instruments and ILBs throughout the quarter, but has added to its fixed rate bond component on yield curve steepening and at the weaker levels. We continue to observe ever tightening corporate bond credit spreads which in many cases at these lower levels are very expensive in our view. However, some pockets of opportunity continue to exist which we have identified and added to the portfolio. Sizeable primary market issuance has taken place during the first quarter of this year, which was welcomed by institutional investors searching for yield and further diversification. The largest bond issues continue to be from the banks with noticeable newcomers to the capital market; many of them being the listed property companies. Strong momentum has led the listed property sector higher over the past quarter, very similar to that which took place towards the end of 2011. Not only did lower bond yields assist on the back of a stronger rand, but some blanket buying might have taken place to gain exposure to the sector. Trading volumes in property stocks reached record levels in March, outperforming the previous high achieved by approximately R1 billion, or close to 20%. This pushed the sector to deliver a total return of 8.0% for the quarter. The announcement of a 15% dividends tax in the Budget sent the preference share sector reeling, but by the end of the quarter losses had more than reversed, resulting in a return of 1.23% from preference shares for the quarter. Preference share yields were all adjusted upwards on 1 April 2012 to a higher percentage of prime, by the amount of the STC saving passed on by issuers, and average yields on bank preference shares are now in the region of 7.08%. Corporate preference shares currently yield 8.63% on average, but these higher yields are now subject to 15% tax. We continue to seek good value assets that on a risk-adjusted basis provide investors with an attractive return. The fund's objective is to achieve a return greater than cash over the long term.

Portfolio managers
Mark le Roux and Tania Miglietta

The fund had a phenomenal year, returning 10.5% and outperforming cash by over 5%. This return was achieved by locking into attractive real interest rates from inflation-linked bonds before these rallied, hedging interest rate risk at appropriate times and having an allocation to offshore bonds which provided superior yields versus their local equivalents.

The All Bond Index registered a return for the year of 8.80%, quite pedestrian and without much capital gain. The best performing domestic bond was the R203 (2017 maturity) which generated a return of 10.80%, while the worst performing bond in the index was the ultra long dated R209 (2036 maturity), returning only 2.70%. This outcome was a result of the yield curve steepening during the year.

Inflation-linked bonds had a stellar year with the index returning 13%. The 5-year government inflation-linked bond produced 16.5%, the top return amongst the bonds in the inflation-linked index.

Yields on very short dated inflation-linked bonds went negative (R189 2013 maturity), closing the year at a real yield of -0.15%. This was fuelled by demand for inflation protection, which increased sharply as headline inflation breached the upper end of the Reserve Bank's target range. Short-term money market rates of 5.5% are now returning a negative real return, something we have not seen in South Africa for many years.

2011 was characterised by a combination of rising inflation, a depreciating currency (the rand lost 22% against the US dollar), rocketing food prices and a materially increasing fiscal deficit; all of which would normally be negative for the bond market. Despite this, global growth concerns, plunging global bond yields (10-year US Treasury is now yielding less than 2%), worries over the fiscal situation of a number of European countries, continued foreign bond investor appetite for yield along with record low domestic short-term interest rates, resulted in a decent offset to the fundamental negative backdrop for bonds.

As we move ahead into the new year, we expect inflation to remain above the upper end of the 3% - 6% target range during the course of 2012. The main drivers appear to be rising food prices combined with the currency depreciation experienced last year. The maize price again reached new highs in December, with the year-on-year percentage change at 99% for the last 12 months. This has a direct and negative impact on inflation. The next move in short-term interest rates, we believe, is likely to be up. However, given the relatively dovish stance of the Monetary Policy Committee, this will most likely only take place towards the second half of the year.

With US Treasuries yielding less than 2%, a sell-off in global bonds is a major risk to the domestic bond market, especially combined with the large South African government bond funding requirements we face this year. If the Reserve Bank waits to take action against the rising inflation trend there could be major ramifications for the local bond market - the longer they wait, the more entrenched higher inflation expectations become.

The fund's inflation-linked bond exposure at 17.25% has provided inflation protection as rising inflation is directly factored into the bond's total return. As inflation rises, so does the return on these bonds. The corporate bond holding has also delivered good returns as corporate spreads have compressed in this environment of limited issuance and the search for yield.

Money market exposure has taken the form of long dated NCDs yielding 8% or more per annum for up to five years and, where appropriate, we hedge this out to reduce interest rate volatility. We acknowledge that investors in this fund seek interest yield, thus we aim to deliver a good long-term interest rate over money market and at times capital gains are achieved as well.

The philosophy of this fund is to bring home a steady income, whilst trying to protect capital.

Portfolio managers
Mark le Roux and Tania Miglietta