Economic overview

The second quarter of 2014 rewarded investors with positive nominal returns across most global asset classes, the exception being UK breakevens, a measure of expected future inflation. Emerging markets performed strongly, both in debt and equity markets, as localised risks moderated, notably in the Ukraine and Russia, and currencies recovered some of the ground lost in the latter half of 2013. The quarter will perhaps be remembered as one of exceptionally low volatility across equity, rates, credit and foreign exchange markets, with record yield lows in some bond markets and record highs on some equity bourses as markets continued to be buoyed by global liquidity. What the US Federal Reserve has taken away, the Bank of Japan and European Central Bank (ECB) have replenished.

A succession of revisions to US GDP saw the economy eventually contract 2.9% in the first quarter, after initial positive estimates proved to be undone by 'the weather', a catchall that has been blamed for this seasonal blip, but has now been largely brushed aside. Jobs data remains positive and purchasing manager indices are trending higher, while wage pressure remains benign. These are conditions one might normally associate with the early to mid-stage of an economic recovery, although market prices suggest we are further along that path. In Europe, economic conditions are not as strong, but they are improving, with some positive growth and a primary surplus for the region as a whole, as efforts to tackle budget deficits bear fruit. This has led to more pronounced (but expected) ECB policy action, culminating in a negative deposit rate and programme of Targeted Longer Term Refinancing Operations (TLTROs) in an effort to spur lending to small and medium-sized businesses in Europe. In Japan, the central bank's efforts to induce inflation looked as though they had succeeded as consumer price inflation hit a 23-year high of 3.2% in May.

Market overview

In the global LIBOR markets, rates remained low in line with the central bank base rates, illustrating the easy liquidity conditions for financial institutions across all major markets. The EUR three-month LIBOR fell back in response to the ECB's action, having spiked in the first quarter, and ended June at 0.21%. USD three-month LIBOR moved little, ending the quarter at 0.23%, while the GBP three-month LIBOR rate edged higher to 0.55%.

The main driver of absolute returns in the fund remains the ZAR exchange rate movements versus the basket of foreign currency denominated bonds the fund invests in. These currency movements are more volatile than the returns generated by the underlying bonds. This quarter, the rand weakened against the dollar by 1%, against the EUR by 0.3% and against the pound by 3.5%, which was very strong as investors priced in central bank rate hikes earlier than expected. The fund returned 0.42% over the quarter, 10.81% over one year, 15.41% per annum and 5.97% per annum over three and five years respectively.

Portfolio activity and positioning

The fund remains invested in bonds or bills of high credit quality, with low interest rate and credit spread durations. Credit quality at the end of June was AA-, with the fund invested in UK and Belgian treasury bills for liquidity and in short-dated investment-grade bonds, including the developmental European issuers EIB and KFW, as well as JP Morgan, Westpac and Morgan Stanley bonds. The AAA exposure has fallen back in favour of AA- rated bonds and bills. The duration of the fund remains relatively short, with interest rate and credit spread durations at 49 and 50 days respectively. The regional split remains neutral in terms of currency positioning, with the fund evenly invested across USD, GBP and EUR assets.

Market Overview

The second quarter of the year saw increased volatility and a continuation of the risk on/risk off tone that has dominated markets lately, driven almost entirely by central back actions and rhetoric. Initially, the first quarter's positive tone continued into the second quarter, driven by the Bank of Japan's announcement of outright purchases of Japanese government bonds of approximately 7.5 trillion yen per month, which further fuelled the global markets' addiction to liquidity. This positive tone quickly changed in the second half of the quarter with comments from the US Federal Reserve Chairman, Ben Bernanke, about a possible tapering of the level of bond purchases (quantitative easing (QE)) earlier than the markets expected, which led to a large back up in yields and a sell-off in risk assets as the markets realised that the end of the free lunch may well be approaching.

Investment grade credit markets had some geographical divergence with US spreads, 13bps wider to 152bps, EUR spreads 9bps tighter to 147bps and GBP spreads 4bps tighter to 179bps. In equity markets, this divergence was reversed, with the S&P 500 up 2.4%, the Euro Stoxx 50 down 0.8% and the FTSE 100 down 3.1%. The government bond markets felt the brunt of the QE tapering fears with a large back up in yields: the German 10-year yield was up 44bps, the US 10-year yield 64bps and the UK 10-year yield 67bps.

In the three-month LIBOR markets, the liquid conditions across all three markets remained broadly the same with the EUR LIBOR up 2bps to 0.15%, the USD LIBOR down 1bps to 0.27% and the GBP LIBOR flat at 0.51%. In the 12-month LIBOR markets, the EUR LIBOR was up 4bps, the USD was down 5bps and the GBP was down 1bps.

Portfolio overview

The fund returned 8.89% over the quarter and 21.2% over one year, mainly driven by the rand exchange rate movements versus the basket of foreign currency-denominated bonds the fund invests in. These currency movements are normally significantly greater and more volatile than the returns generated by the underlying bonds. This quarter, the rand again depreciated significantly against all three currencies: -8.0% against the EUR, -6.6% against the USD and -6.9% against the GBP.

Portfolio activity and positioning

The fund is still defensively positioned, with high credit quality and short interest rate and credit spread durations. The weighted average rating factor increased slightly to 89, which implies an average rating of A and approximately 27% of the fund is invested in AAA-rated bonds to maintain a liquidity buffer. The weighted average interest rate duration is around 120 days and the credit spread duration is slightly higher at around 140 days.

The regional split remains neutral in terms of currency positioning, with the fund evenly invested across USD, GBP and EUR assets.