The Fund's exposure to African Bank (ABIL) instruments, were written down in line with the SARB's communication, with remaining exposure side-pocketed. The total impact of writing down the ABIL exposure was 2.14% of the total portfolio. The 12 months return on the Fund after taking into account the impact of ABIL at the end of the third quarter is 6.0% compared to the benchmark return of 5.2%. The modified duration of the fund was reduced from 0.93 year to end the quarter at 0.78 years. The Fund's exposure to listed property was reduced as the sector was becoming overvalued.

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% hair-cut. 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 seeks to maximise overall return, in the form of both income and capital growth. It will be consistent with the investment of funds in a flexible mix of predominantly non-equity securities.

The portfolio will invest its assets in South African investment markets at all times and will be permitted to make investments in a flexible mix of non-equity securities, and any other securities that are consistent with the portfolio’s investment policy, which will include but will not be limited to preference shares. This portfolio may also invest in other similar collective investment schemes.

The size of the Fund reduced marginally to end the second quarter at R2.1 billion. The modified duration of the fund was reduced from 1.0 year to end the quarter at 0.93 years. The liquidations were funded by the sale of fixed assets, thereby reducing the modified duration. The Fund benefited from its exposure in the property asset class which performed well during the quarter.

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.

Fund Review

The modified duration of the Fund remained relatively unchanged at 1.0 year, defensive in a market that still experiences volatility. The listed property positioning was initially reduced at the beginning of the quarter as property returns were under pressure. During the last month of the first quarter the position was slightly increased, capturing the capital appreciation that came as bond yields declined.

Looking Ahead

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.

Fund Review

The STANLIB Flexible Income Fund's size increased from R2.44 billion to R2.77 billion during the quarter. The modified duration of the Fund was reduced from 1.2 years to 1.0 year as market volatility continued. The exposure to property was further reduced as bond yields moved higher. Given the view that interest rates are at the bottom of the cycle, the Fund will remain defensively positioned. New paper introduced into the Fund included PPC and Aspen.

Looking Ahead

The fourth quarter returns in the bond market where a small positive of 0.1%, largely the result of pressure coming to bear following the FOMC indicating that the tapering of Quantitative Easing will be effective from the beginning of 2014. South Africa along with other emerging markets paired the gains from the previous quarter as yields tracked higher on risk off trade, discounting the withdrawal of liquidity. The FOMC's confirmation of tapering also led to US bond yields moving higher, with the 10 year Treasury note touching 3%.

South Africa had a challenging year as it had country specific issues to grapple with, i.e. the twin deficits which remained wide even in the fourth quarter. The country was classified in the socalled 'fragile 5' which is a group of countries most at risk when the Fed withdraws liquidity due to dependency on foreign flows. As a result, volatility continued as the benchmark RSA 10 year bond's yield ended the fourth quarter at 7.90% from 7.56%. The deterioration was also largely in line with other emerging markets bond yields. The medium term budget statement held in October showed that debt levels in South Africa will increase over the next three years, with the budget deficit only consolidating in three years' time. The combination of accommodative monetary policy and continued higher issuances led to a steeper yield curve, where the yield gap between the R186 and R157 increased from 1.83 basis points to 2.07 basis points.

The fourth quarter saw foreigners liquidate R11 billion of their holding. The slower pace of inflows led to a weaker currency as the current account widened at the same time which may present an inflation threat in future. The outlook for 2014 in terms of monetary policy is for the SARB to keep the repo rate flat in an attempt to boost economic growth. Inflation trending inside the target range in the last quarter of the year will provide the MPC with more justification to prolong the tightening monetary policy. South Africa will remain on the radar of rating agencies until fiscal consolidation is sustainable.