The fund returned 0.37% in September and 1.65% for the quarter, bringing its return for the 12-month period to 7.83%. The fund return remains ahead of the Short Term Fixed Interest (STeFI) three-month index (5.41%) and its benchmark (5.96%) over the one-year period. The third quarter of 2014 was a torrid time for the SA bond market, which was buffeted by crosswinds from global markets, the failure of African Bank as well as adverse movements in the local interest rate, currency and inflation. Despite these developments, bonds still managed to produce a positive return for the quarter, with some support from the stronger US bond market. The return of 2.2% on the All Bond index in Q3 outperformed cash (1.5% for the quarter) and inflation-linked bonds (1.0%).

Short-dated forward rate agreements (FRAs) suggest that domestic rates will normalise at 6.25% by year-end, and at 7.25% by the end of 2015 (up from 6.75% a month ago). While the global background was somewhat fraught, domestic factors were also not supportive of bonds. Inflation surprised on the upside and remained above the top of the 3-6% target range, with August CPI rising to 6.4%. There were two MPC meetings in the quarter: the SARB raised the repo rate by 25bps to 5.75% at the July meeting, but left rates unchanged at the September meeting as growth had once again deteriorated. The major news at the September meeting was the announcement by Gill Marcus, whose term as governor ends in November, that she would not be available for another term. (Deputy governor Lesetja Kganyago has since been appointed to replace Marcus.) Even amid indications of falling food and energy inflation, the rapid rand depreciation near quarter-end kept fears of inflationary pressures alive. Comments by SARB officials have made it clear that we remain in a hiking cycle - policy is still very accommodative and needs to normalise - and that disagreements are over the timing of, rather than the need for, further hikes.

However, as we have seen so far this year, the degree to which the hawkish rhetoric from the monetary authorities translates into action is not necessarily straightforward. So while they maintain that South Africa is in a hiking cycle, rate hikes may not be as frequent as the rhetoric implies. Consequently, current pricing of interest rate expectations seems fair. Inflation should start to top out soon as lower food and oil prices begin to feed through (although this is also critically dependent on rand movements).

Three- and five-year negotiable certificates of deposit (NCDs) - respectively 8.31% and 8.95%, at quarter-end - are looking more attractive relative to the interest rate outlook. Nonetheless, since market expectations are increasingly in line with our forecasts, the fund maintains a neutral outlook on the duration risk in its holdings of these instruments. Bank funding pressures have increased due to a combination of new regulatory requirements (Basel III), the collapse of African Bank and the increasing drawdowns on loan facilities by infrastructure products. As such, bank credit spreads have continued to widen over the course of September, with the five year floating rate NCDs moving from around 95bps to approximately 135bps. This has enhanced the attractiveness of these floating rate assets for the fund. The fund has actively been switching out of much of its tighter, shorter-dated bank funding exposure to these more attractive five-year spreads. We however still maintain a cautious outlook and prefer to be selective in the fund's credit exposure given the current phase of the credit and business cycle. It should be emphasised that the bond market saw a rather abrupt turnaround in September itself. Yields fell about 40bps between end-June and early September, but then deteriorated sharply during the rest of the month. While US bonds bolstered the local market for much of the quarter, this support fell away at quarter end as SA bonds succumbed to a significantly weaker currency. The rand was hit by general emerging market nervousness, and undermined further by local "twin deficit" data. Both the trade account and fiscal account for August showed significantly wider deficits than expected. Thus far bonds have been relatively resilient given the extent of the move in the currency.

The value point on the bond and interest rate curve remains along the longer end, and the fund continues to hold very attractively priced credit in those tenors. To maximise return, we have started to remove much of the duration hedges, which were added earlier in the quarter, on these instruments as duration valuations are moving closer to our fair value estimate. This has increased the yield of the fund but also added duration. We believe current valuations justify this trade-off. In addition, we continue to add selected longer-dated fixed and shorter-dated floating-rate corporate bond exposure through new issuances. Only those that offer attractive entry levels, based on our assessment of the underlying credit quality, will be considered. The twin deficits reveal both a lack of fiscal consolidation (especially when compared to our peer countries) and an inability of the trade account to benefit from a significantly weaker currency (probably due to strike action). The trade account and fiscal account data have disappointed expectations for most of this year, and played an important part in driving down the local currency. The rand weakness has also been blamed on general global conditions, which have resulted in a stronger dollar and weaker emerging market currencies. Partly due to these factors, foreigners were large net sellers of bonds (of almost R25bn) in the third quarter. The weakening in the currency during the quarter (-5.5% spot return) has justified our high allocation to offshore assets and helped to protect the fund from adverse duration movements. The currency is probably, at worst, fairly valued at current levels and one would expect that this could - finally - assist in a recovery of the trade account, particularly once mining and manufacturing production stabilise following industrial action. As such we have started to reduce the fund's offshore exposure (to a more neutral position) through the use of currency futures. This allows the fund to maintain its holdings of offshore assets but synthetically restores its exposure to rand. This has the effect of not only reducing our net offshore exposure but also enhancing the yield of the fund. The fund continues to hold exposure to highyielding emerging markets with strong fundamentals, particularly those where interest rates have already started to normalise.

The property market continued to push higher in September, delivering a monthly return of 2.18% and an impressive 7.2% for the quarter. Due to the late selloff in the bond market during this period, the yield gap between property stocks and the current 10-year government bond increased to 196 basis points. In an effort to enhance capital returns, we continue to take advantage of any property stocks that offer upside to their net asset value (NAV) valuations. The fund continues to maintain property holdings which offer strong distribution and income growth, and will look to increase this exposure into a rand- or bond-driven sell-off. We also continue to favour preference shares, given the steady dividend yields on offer, and maintain the current level of holdings within the fund. Preference shares are linked to the prime rate and, depending on the risk profile of the issuer, currently yield between 7% and 9.5% (subject to a 15% dividends tax, depending on the investor entity). The change in capital structure requirements as mandated by Basel III will lead to banks issuing fewer preference shares, which will limit availability (and boost possible buybacks). This should enhance the attractiveness of these assets.

Aside from economic developments, the local markets were shaken by the failure of African Bank in early August. The microlender was suspended from trading, placed under curatorship and split into a good bank and a bad bank. While the final outcomes for investors are still unclear, measures to date include a 10%-haircut and maturity extension on senior debt, and the apparent complete loss of capital on subordinated debt. Coronation did not hold any African Bank debt in our bond funds as we did not believe the returns offered enough compensation for the risks involved. However, African Bank caused significant reverberations throughout the SA capital market: some bond funds were forced to either record losses or "side pocket" their African Bank debt and some money market funds "broke the buck". This dealt a blow to confidence, causing a widening in credit spreads, particularly in bank funding. While the weakening in bonds and, especially, the currency should have removed most of the valuation concerns, we remain cautious about a more extended period of weakness in bonds and currency markets. Some concerns remain. The Medium Term Budget Policy Statement due near the end of October will be closely watched. Hopes of fiscal consolidation may be disappointed if Eskom and SAA receive more state support. There are also lingering worries about public sector wage talks and the resulting wage settlement. Concerns over the size of the deficit (and the associated bond market funding) will be heightened amid uncertainty over the extent to which SA can still rely on foreigners to help fund it, especially ahead of expected Fed tightening next year.
We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the South African economy, but believe the current fund positioning correctly reflects appropriate levels of caution. The fund yield of 8.24% and low duration risk should continue to provide an adequate buffer against any adverse short-term moves and assist the fund in meeting its performance target for 2014. The risks are now more evenly poised: looking ahead, there are no indicators that would imply sharp moves either higher or lower in bonds, so returns on bonds are likely to largely match their yield. As is evident, we remain cautious in our management of the fund. We continue to only invest in assets and instruments that we believe have the correct risk and term premium so as to limit investor downside and enhance yield.

Portfolio managers
Mark le Roux and Nishan Maharaj

The fund returned 0.78% in June, bringing its return for the 12-month
period to 8.10%. The fund return continues to be ahead of cash (5.26%)
and its benchmark (5.78%) over the one-year period.
The fixed interest market extended its positive run in June, with the All
Bond Index (ALBI) gaining 0.95% for the month to end the quarter 2.5%
stronger. Inflation-linked bonds (ILBs) outperformed with a return of 1.39%
in June, and 5.9% for the second quarter as a whole. Cash lagged with a
return of 1.45% for the quarter. Over longer time periods, ILBs have had a
stellar run; the 6-month return of 7.6% and 12-month return of 12%
outpaced that of vanilla bonds (3.4% for the six months and 5.4% for the
12 months) and cash (2.83% over 6 months and 5.53% over 12 months).
Short-dated forward rate agreements (FRAs) suggest that domestic rates
will normalise at 6.50% by year-end, and at 7.50% by the end of 2015. The
South African Reserve Bank (SARB)’s Monetary Policy Committee (MPC)
again kept the repo rate unchanged in May. However, the MPC has reiterated
that SA is in a tightening cycle, so further rate hikes are likely.
With May’s inflation print at 6.6%, the SARB’s credibility will likely be a
consideration when the MPC meets on 17 July. Though inflation
expectations were unchanged in the Bureau for Economic Research
(BER)’s second quarter survey, increasing headline inflation will likely filter
through to expectations in coming quarters, and the SARB could move
ahead to contain expectations. However, given the weak growth
backdrop, the hiking cycle should be a moderate one (a point the SARB
has been at pains to emphasize). Furthermore, the MPC has also
communicated that the pace of tightening will take into account policy
normalization in developed markets; with the US Federal Reserve (Fed)
only expected to start hiking rates in the second half of 2015, hikes by the
SARB are unlikely to be front-loaded, nor sizeable (25bp moves cannot be
ruled out). We therefore view current pricing of interest rate expectations
as fair.
Three-year and five-year negotiable certificates of deposit (NCDs) remain
at attractive levels (7.90% and 8.60%, respectively) relative to the interest
rate outlook. However, since market expectations are increasingly in line
with our forecasts, the fund maintains a neutral outlook on the duration
risk in its holdings of these instruments. The value point on the bond and
interest rate curve remains in the longer end, and the fund continues to
hold very attractively priced credit in those tenors. To maximise return, we
will remove the duration from these instruments when we deem valuations
to be stretched, while still picking up attractive credit spreads. The fund
continues to hold such hedges in place, but will look to remove them at
opportunistic levels, thereby adding duration to the fund. In addition, we
continue to add selected longer-dated fixed and shorter-dated floating
rate corporate bond exposure through new issuances that offer attractive
entry levels based on our assessment of the underlying credit quality.
Geopolitical developments added to market uncertainty during the
quarter. The Ukrainian conflict took centre stage earlier in the three-month
period, while renewed unrest in Iraq continues to threaten security of oil
supply. Meanwhile, data coming out of the US suggests a continued
recovery in the labour market, while inflation has also surprised on the
upside. However, negative GDP data from the first quarter shows that the
US recovery is not a foregone conclusion. Nevertheless, the Fed has
continued to taper its asset purchase programme, with monthly purchases
now at $35 billion. At this pace, quantitative easing (QE) should end in
October 2014, with most Federal Open Market Committee (FOMC)
members expecting the first Fed funds rate hike in the second half of 2015
(as mentioned earlier).
Against this global backdrop (along with local developments), the rand
weakened slightly to end the second quarter at R/$ 10.64 (compared to a
level of R/$ 10.53 at the end of the first quarter). The weakening took
place despite foreign bond inflows of R13.8 billion during the three-month
- a reversal from the R28.6 billion in outflows recorded during the first
quarter of the year. The yield on the benchmark R186 bond declined over
the period, falling from 8.39% to 8.31% (smaller than the decline in the US
10-year Treasury yield, from 2.72% to 2.53%).
Local events and data releases were at best mixed. While the current
account deficit for the first quarter showed a surprise narrowing to 4.5% of
GDP, the reason behind the compression (large foreign dividend receipts)
is probably a once-off, and suggests that the deficit is likely to widen
again. The trade account remains in deficit territory, with the year-to-date
deficit already R13 billion wider than that of the comparable period in
2013. While the resolution of the five-month long platinum strike is
encouraging, it may take a few months before full production is restored.
Coupled with the strike in the metals and engineering sector, the outlook
for the current account in the near term is not comforting.
Meanwhile, Standard and Poor’s (S&P) downgraded the SA sovereign
[foreign currency] credit rating to BBB- (one notch above sub-investment
grade) and moved the outlook from negative to stable. S&P notes that
the current rating and outlook reflect the adverse local fundamentals;
therefore the risk of further downgrades by the agency is limited (but not
zero). Furthermore, the local currency rating, which is the one used for
World Government Bond Index inclusion, sits at BBB+ (two notches
above the foreign currency rating and three notches above subinvestment
grade). On the other hand, Fitch affirmed its rating at BBB
(one notch above S&P), but changed its outlook to negative. It is not
inconceivable that Fitch could downgrade SA to bring it in line with S&P’s
rating over the next year or two, especially if signs of fiscal consolidation
do not strengthen by the time of the Medium-Term Budget Policy
Statement (MTBPS) in October this year or the Budget in February 2015.
The fund’s offshore holdings continue to provide protection against
adverse duration movements. Given the recent data releases and
persistent negative socioeconomic developments, we believe the risks lie
in the rand reassuming its role as a pressure valve for the current
vulnerabilities in the SA economy. The fund will use strength in the
currency to increase exposure to its offshore holdings by reducing its
hedges via currency derivative instruments. The fund continues to hold
exposure to high-yielding emerging markets with strong fundamentals,
particularly those that have already started to normalise their interest
rates.
The property market regained some of its shine in June, with a return of
3.37%, bringing the yearly return to 6.33%, partially meeting our
expectations around valuation and yield for 2014. This slightly increased
the yield gap between property stocks and that of the current 10-year
government bond to 186bps. In an effort to enhance capital returns, we
continue to take advantage of any property stocks that offer upside from
their respective net asset values (NAV). The fund continues to maintain its
property holdings, given their strong distribution and income growth, and
will look to increase this exposure into a rand- or bond-driven sell-off.
We also continue to favour preference shares, given their steady dividend
yields, and maintain the current level of holdings within the fund.
Preference shares are linked to the prime rate and, depending on the risk
profile of the issuer, currently yield between 7% and 9.5% (subject to a
15% dividends tax, depending on the investor entity). The change in
capital structure requirements as mandated by Basel III for many of the
issuing banks will also lead to decreased issuance and preference share
availability (and possible buybacks), which in turn will enhance their
attractiveness.
We continue to be cautious of risks emanating from the dislocations
between stretched valuations and the underlying fundamentals of the SA
economy, but believe the current fund positioning correctly reflects our
cautiousness in light of all the relevant risk factors. The fund yield of
7.635% and very low duration risk should continue to provide an
adequate buffer against any adverse short-term moves and assist the fund
in meeting its performance target for 2014. Broadly speaking, SA
fundamentals appear to have reached a trough. While the outlook does
not necessarily see a sharp improvement, the likelihood of a further
deterioration in fundamentals is limited. At current levels, both the
currency and domestic bonds appear to have the bad news priced in,
suggesting that the trajectory in bond yields going forward is likely to be
sideways.
We remain cautious in our management of the fund (as mentioned
above), and continue to only invest in assets and instruments that we
believe have the correct risk and term premium so as to limit investor
downside and enhance yield.

The fund returned 0.97% in December and 4.04% for the quarter. This brings its return for the 12-month period to 7.16%, well ahead of cash (5.32%) and its benchmark (5.54%). Over three years, the fund has returned 9.81% per annum, outperforming both cash (5.82%) and bonds (8.32%).

Fixed interest assets returned to positive growth in December, after experiencing a tough time in the preceding month. However, the performance of vanilla bonds for the fourth quarter as a whole was still marginal, with the All Bond Index (ALBI) returning 0.1%, while cash returned 1.3%. Inflation-linked bonds (ILBs) outperformed, increasing by 2.8% between October and December. Overall, 2013 was a poor year for fixed interest assets, with the annual return for the ALBI coming in at 0.6% (vs. 16% in 2012), while ILBs were slightly better at 0.8% (vs. 19.4% in 2012). Both asset classes lagged cash, which returned 5.32% for the year.

The dismal performance of the fixed interest asset class was driven mostly by one factor - expectations around quantitative easing (QE) tapering. After the initial announcement in May 2013 by the US Federal Reserve (Fed) that they intended to scale back their QE programme and subsequent speculation on the timing thereof, the Federal Open Market Committee (FOMC) finally announced in December 2013 that tapering would commence in January 2014, with monthly asset purchases reduced by $10 billion (to $75 billion). This followed a few months of better than expected employment reports. However, despite the start of QE tapering, the Fed statement contained what were deemed to be dovish comments relating to a delay in short-term rate hikes. In essence, while the Fed allowed long-term rates to drift higher, the committee expressed that short-term rates would remain lower for even longer, should the economic recovery not gain traction. Subsequent to the tapering decision, the yield on US 10-year Treasuries increased further, touching the 3% handle.

Locally, the fourth quarter saw a reversal in foreign flows into the local bond market, surpassing the outflows seen at the height of uncertainty in the second quarter. Non-residents were net sellers of R16.4 billion worth of South African bonds (from being net buyers of R14.8 billion in the third quarter). These were the largest outflows from the local bond market since the fourth quarter of 2010. As a whole, calendar 2013 saw just over R1 billion in foreign flows into domestic bonds, a far cry from the R85 billion recorded in 2012. The net selling by non-residents during the quarter, resulted in a further weakening of the rand to end the quarter at R/$ 10.49, compared to a level of R/$ 10.03 at the end of the prior quarter. Over the course of the year to end-December, the rand weakened by about R2 against the US dollar, having opened the 12-month period at R8.50/$. Given the flows and currency backdrop, local bond yields rose further during the fourth quarter, with the yield on the benchmark R186 ending the period 30bps higher than at the end of the third quarter.

Turning to local fundamentals, third-quarter data for the current account showed a further deterioration to 6.8% of GDP, from 5.9% in the second quarter. While not the sole reason for the deterioration, the 8-week long strike in the automotive sector did not help matters. On the other hand, there was an increase in foreign direct investment (FDI) in the third quarter; a welcome development given South Africa's reliance on portfolio flows to finance its current account deficit. As highlighted previously, we believe that the end of cheap money will make it increasingly difficult for South Africa to attract foreign flows, given the challenging state of our fundamentals. Diversification away from portfolio flows to less volatile types of foreign flows, like FDI, would help alleviate pressure on the currency.

Meanwhile, the Minister of Finance tabled the Medium-Term Budget Policy Statement (MTBPS) in late October. While methodological changes led to a narrowing of the projected budget deficit for 2013/14 (from 4.6% to 4.2% of GDP), consolidation in public finances has been pushed out (again) by a year. However, the commitment to fiscal restraint announced by the Minister, including the expenditure ceiling and the cutting of perks to Cabinet shows a willingness on the part of the authorities to address the challenges SA inc. faces. Going forward, the growth outlook and its implication for government revenue collection will be critical in addressing the budget deficit.

Third-quarter GDP data was also released during the period. The automotive sector strike mentioned above negatively impacted the manufacturing sector, with an overall negative impact on GDP. Growth of 0.7% was recorded for the third quarter, putting the year as a whole in line for growth in the region of 2%. Meanwhile, after breaching the upper end of the target band in the third quarter, inflation dipped back within target in the first two months of the fourth quarter, with November's print at 5.3%. While this inflation print is likely to ease the pressure on the Monetary Policy Committee to begin tightening policy, the volatility in the external environment and its impact on the rand have seen the South African Reserve Bank (SARB) strike an increasingly hawkish tone in recent meetings, with the underlying message (in our opinion) that if a weakening rand threatens the inflation outlook, interest rates will have to be hiked.

The property market performed in line with bonds as the sector registered a positive performance of 1.00% in December, with the yield gap between property stock yields and current 10-year government bond yields contracting further in December. We continue to look to add to our current holdings in a yield or rand-led sell-off and also look to take advantage of any property stocks that provide upside from a NAV valuation perspective to enhance capital returns. As such, we have selectively added some exposure to offshore and local property to take advantage of attractive valuations. These property stocks include Attacq, Accelerate and Hyprop.

We continue to favour preference shares for their steady dividend yield, and will continue to opportunistically increase our holdings in the fund. Preference shares are linked to the prime rate and, depending on the riskiness of the issuer, currently yield between 7% and 9.5% (subject to a 15% Dividends Tax depending on the investor entity). The change in capital structure requirements as mandated by Basel III for many of the issuing banks will also lead to decreased issuance and preference share availability (and possible buy backs), which will increase their attractiveness.

The sell-off in the ZAR currency market (-1.88% for December) continues to buoy inflation expectations, which has kept front-end rates elevated. Shortdated FRAs suggest that rates will normalise to 7.50% in the next two years. We continue to believe this pricing to be too aggressive given the tailwinds from the poor growth outlook in South Africa. Therefore, three-year and fiveyear NCDs are at levels which we deem sufficient to buffer against a possible normalisation of interest rates by the SARB. We therefore continue to opportunistically remove some of our interest rate hedges against our holding of these instruments. The hedges we currently have in place against our longer-dated corporate holdings have served us very well over the past year. However, with longer-dated government bonds trading well above 9% at present, putting their companion corporate bonds well above 10%, we are more inclined to add duration on a through-the-cycle view. We therefore continue to hold our hedges in place, looking to remove them at opportunistic levels, adding duration to the fund.

We remain cautious going into 2014, in spite of the meaningful correction in bond yields in 2013. We are of the opinion that domestic yields are now closer to what we believe to be fair value; however, with the QE taper already in effect, we think that foreign investors will be more discerning of domestic fundamentals when investing in emerging markets. We do not see a (meaningful) narrowing of the twin deficits over the next year, and we expect the wide current account deficit to continue to put the currency under pressure. With the rand now on the wrong side of R10.50, we remain wary of becoming overly bearish on assets as their valuations cheapen to the global financial crisis levels of 2008. We therefore remain ready to take advantage of any opportunities that may present themselves which we feel correctly reflect the expected volatility and movement in interest rates through the cycle. The fund is defensively positioned with a decent portion invested in cheaply priced offshore assets, however, to provide protection in the event of a further material sell-off in ZAR or risky assets.

Our view to managing the fund remains cautious and we continue to invest in assets and instruments that we believe have the correct risk and term premium embedded in them so as to limit investor downside and enhance yield.