Fund Review

The Fund size reduced from R7.6billion to end the quarter at R6.8 billion. The Fund's exposure to African Bank instruments were written down in line with the SARBs communication, with the remaining exposure side- pocketed. The impact of the African Bank write down to the portfolio was a 0.44% drop in value. The modified duration of the portfolio remained unchanged at 0.10 due to the portfolio being invested in floating rate notes.

Looking Ahead

The bond market returns for the third quarter of 2014 remain in positive territory as the market continued to trade in a range, with the yield on the RSA 10 year government bond remaining relatively unchanged. The benchmark opened at 8.31% before closing the quarter at 8.32%. There was some intra quarter volatility though, as the market traded a high in yields of 8.40% and a low of 7.86%. This range is a reflection of the conflicting challenges that South Africa faces as growth disappoints but inflation breached above the target, which puts the SARB in a stagflationary bind. Although the market was influenced by SA specific issues which saw the currency weakening by at least 6% during the quarter, it also took its cue from the volatility of the US bond market and event risk from Europe. The impact of this volatility was also felt in other emerging markets. The JP Morgan emerging market bond spread (EMBI+), has increased from 280 to 316 basis points over the US benchmark yields as the markets were worried about the prospects of the US increasing borrowing rates and the threats of geo-political risk in Ukraine and the Middle East. As these markets are correlated to South Africa, the sovereign bond spread also increased from 180 to 205 basis points. The volatility index (VIX) increased from a low of 10.30% to end the quarter at 16.30%.

During the third quarter the SARB increased the repo rate by 25 basis points to 5.75%, indicating that the risk of future rate moves are still on the upside. On the corporate bond front, African Bank was placed under curatorship after continuously disappointing the market by posting bad trading updates and results against market expectations. This led to senior debt holders taking a 10% haircut. Corporate bond spreads widened post the ABIL debacle as investors demanded additional premium for low liquidity assets. Liquidity spreads widened by an average of 20 basis points as a result.

The path for SA bond yields will still be firmly linked to US treasuries given the high correlations. The improving economic data from the US and the forward guidance from the Fed will influence the path for EM yields and currency movements.

The portfolio's primary objective is a reasonable level of current income and maximum stability for capital invested. Investments will include a flexible mix of non-equity securities, including but not limited to money market instruments, bonds, fixed deposits, listed debentures and other high yielding securities, as well as any other securities which may be approved by the Registrar from time to time and which are consistent with the investment policy of the portfolio, to the maximum levels permitted by the Collective Investment Schemes Control Act, No 45 of 2002, and the Regulations thereto, as amended from time to time. The portfolio will be managed in compliance with the Prudential Investment Guidelines that are applicable to retirement funds from time to time.

Fund review

The returns from the fund were better than those from money market portfolios, although the interest rate risk of the fund is significantly low. The modified duration of the portfolio was 0.1 at the end the second quarter. Instruments bought with the inflows were Imperial Group, Landbank and ABSA floating rate notes. The fund continues to invest in floating rate notes only.

Looking Ahead

The second quarter of 2014 saw bond yields marginally decline leading to returns for the All Bond Index benchmark remaining in positive territory. The benchmark returned 2.5% during the second quarter as volatility in the rates and currency markets across emerging markets reduced as sentiment turned positive, driven by the continued search for yield from risk assets as Euro yields declined further. Longer dated NCD rates traded in a tight range of 6.85% to 7.05% during the second quarter, tracking the movements of the Rand. During the quarter the ECB reduced the minimum bid rate to an all-time low and introduced Targeted LTRO meant to prevent deflation.

Emerging markets continued to receive inflows as the Fed's tapering policy is now fully discounted by the market, but at the same time the FOMC indicated patience in lifting policy rates. The EMBI spread continued to compress over the quarter from 330 basis points to end at 280 basis points. The VIX remained subdued reaching pre-crisis levels. The low economic growth, protracted strikes, rigid budget and current account deficits finally led to rating agencies downgrading the country. S&P downgraded both the local and foreign currency ratings, with the latter now sitting just a notch above junk status at BBB-. Fitch downgraded the outlook from stable to negative. Despite all the risks, foreign investors continued to buy South African bonds in line with other emerging markets, with their purchases topping R20 billion for the current year.

The SARB left interest rates unchanged despite inflation breaching the target but recent statements indicated that interest rates are definitely on the way up. The FRA market is discounting the repo rate, reaching 7% one year out. The yield curve steepened from the previous quarter as markets paired back expectations of aggressive rate hikes and continued supply. Inflation linked bonds are well bid in the market leaving break even inflation at elevated levels. The path for South African bond yields will still be firmly linked to US treasuries given the high correlations between the two. The improving economic data from the US and the forward guidance from the Fed will influence the path for EM yields and currency movements.

The STANLIB Extra Income Fund size as at the 31st March 2014 was R6.9bln from R5.6bln as at the end of December 2013. The fund is largely invested in floating rate notes, which provide a level of capital protection given that short term rates are now firmly on the upside after the SARB surprised the market by hiking rates in January 2014. The fund's returns continued to be better than money market returns, but with an added advantage of a defensive positioning in term of modified duration which was at 0.1. New investments in the fund were used to purchase MMI group, Nedbank, Absa and Investec floating rate notes.

The first quarter of 2014 opened with more volatility when compared to last year. The ALBI benchmark returned 0.9% during the first quarter after the market staged a late recovery. The RSA 10 year bond traded to a high of 8.90% before ending the quarter at 8.39%. The 12 months NCD rate increased from 6.025% to end the quarter at 6.975%. Returns for longer-dated maturities were a lot better than shorter-dated bonds. The budget speech was received well by the market, although the supply of bonds from the government will still be concentrated in the long end of the yield curve. The demand for risk assets globally improved in March as emerging markets in general benefited from the risk-on trade. Foreigners who had shunned emerging markets started to warm up to them as they looked cheap relative to developed markets on a carry trade basis.

The extent of the volatility is evidenced by the path of the JP Morgan EMBI spread which started the quarter at 332 basis points (bps), touched a high of 406bps and retraced all the loses to end the quarter at 326bps. These gyrations catapulted the Rand to a low of R11.50 before recovering to end the quarter at R10.52. Foreigners ended up being net sellers R4 billion South African bonds which was much better than at the height of the sell-off. The sell-off in the Rand led the SARB to revise higher the currency pass through risks to inflation, and hiked the repo rate by 50bps. The rates market sold off aggressively, particularly in the short end of the yield curve, with the forward rate agreement (FRA) discounting a further 2% in rate hikes. The SARB, however, dampened those expectations and as a result the market retraced. The impact of the hike led to an aggressive flattening of the yield curve, with the yield differential between the R186 2026 and R157 2015 paper compressing from 210bps to a low of 130bps before correcting to end the quarter at 160bps.

The outlook for interest rates is now firmly on the upside as inflation is expected to breach the 6% top of the target range. The market is already discounting the hikes as the FRAs have adjusted higher. The path for South African bond yields will also be firmly linked to the US treasuries movements in the face of tapering and potential early hikes in 2015.