The All bond Index gained 2.21% for the 3rd quarter with the long end outperforming. The respective returns were: 1-3 year +1.15%, 3-7 year +2.01%, 7-12 year +1.84% and 12+ years +2.51%. Inflation linked bonds underperformed over the quarter gaining 1.02% while cash returned 1.49% over the period.
The US Federal Reserve Bank continued its course of tapering its monthly bond buying programme and as expected this should be concluded in October 2014. US Treasury yields traded from a high of 2.68% to a low of 2.30% in the quarter. Global geo-political risks kept US bonds supported for most of the quarter with yields fluctuating according to the strength of economic data and its effect on the anticipated timing of normalisation of interest rate policy. US employment data did not please markets sufficiently over the quarter to accelerate expectations of, or communication as to the timing of the first policy rate hike. US GDP for the second quarter surprised to the upside coming in at 4.6% (qoq) a reversal from -2.0% in the first quarter.
The European Central Bank surprised markets, delivering extreme stimulatory measures at its September policy meeting including a 10 bp cut of all three policy rates(the deposit facility rate cut to -0.20%). This move came in the wake of persistently disappointing data releases from Europe leading to concerns of recession and deflation.
The South African economy grew by 0.6% for the 2nd quarter as the prolonged platinum sector strike continued to weigh. Consumer inflation peaked at 6.6% in June and dipped to 6.4% for August. In July the MPC hiked rates by 25 bp's signalling its intention to contain inflation and stay ahead of US policy normalisation but to move in smaller steps considerate of economic growth implications. The statement was dovish on balance with a large revision of domestic GDP to 1.7% from 2.8% for 2014 and 2.9% from 3.1% for 2015. Septembers MPC meeting left rates unchanged and revised forecast inflation lower to 6.2% for 2014 and 5.7% for 2015 as well as GDP to 1.5% (2014) and 2.8%(2015).
African Bank was put into curatorship in August and all trading in its assets suspended. The SA Reserve bank, PIC and a consortium of banks are committed to rebuilding the business with assets being split between a good and bad bank. Equity and subordinate debt was written to zero while senior unsecured bonds revised to 90% of face value. Corporate credit spreads were adversely affected by this development as a new precedent has been set for future such credit events.
Domestic bond yields were range bound through the quarter ending towards the higher end. Looking forward it is expected that bond yields will remain susceptible to the global growth picture as well as the timing of US policy normalisation. We remain in a hiking cycle domestically with the pace thereof determined by economic growth versus inflation. The ABSA bond fund is moderately short duration in anticipation of US policy normalisation and its relative effect on the South African yield curve over the short to medium term.

The ALBI gained 2.50% for the 2nd quarter as the belly outperformed the rest of the yield curve. The respective returns were: 1-3 year +1.80%, 3-7 year +2.90%, 7-12 year +2.90% and 12+ years +2.10%.

Inflation linked bonds outperformed over the quarter gaining 5.9% while cash returned just 1.45% over the period.

The US Federal Reserve Banks tapering of its monthly bond buying programme continued for the period as expected and should be concluded in October 2014. US Treasury yields were buoyed for the quarter as disappointing negative 1st quarter GDP growth supported maintaining the forward guidance for a sustained period of low interest rates. US 10 year treasury bond yields dipped from 2.80% to 2.50% over the quarter. US employment data has been steadily improving and the Fed will accelerate the timing of interest rate policy normalisation should this positive trend continue. The US Federal Reserve is expected to begin increasing interest rates during the second half of 2015.

The European Central Bank in an attempt to increase inflation cut the interest rate on bank funds to -0.1% for the first time at its June meeting and introduced quantitative easing stimulus by way of cheap four year loans to banks (starting in September) provided the credit finds its way to the private sector. The European Central Bank is willing to move further if necessary. These steps have supported emerging market yields.

This low US yield environment and forward guidance has supported emerging market yields although increasing geopolitical risks in Ukraine and Iraq have created intermittent volatility during the period and are cause for concern.

The domestic economy contracted by 0.6% for the 1st quarter mainly due to the prolonged strike in the platinum mining sector. Consumer inflation increased to 6.6% in May above the 6.0% ceiling of the target range as the weaker currency effect continues to materialise in the basket. The repo rate was left unchanged in May but Reserve Bank guidance maintains that we are in a hiking cycle and that positive real rates are required and for South Africa to be adequately positioned for the US rate normalisation. The dilemma of low growth versus high inflation has reduced the expected extent of the hiking cycle however.

Standard and Poors downgraded South African foreign currency rating to BBB- and improved the outlook to stable, Fitch maintained a BBB rating but reduced the outlook to negative, the main motivation being concerns over economic growth.

Domestic bond yields should be supported over the third quarter but remain vulnerable to eventual global interest rate normalisation. The ABSA Bond fund remains moderately short duration relative to the ALBI but acknowledges that the impact of global normalisation may well be less and the timing more protracted than had been previously anticipated and will respond to any new developments as required.

The All Bond index gained 0.13% for the fourth quarter of 2013. Shorter dated bonds performed the best for the quarter as the 1-3 year index gained 1.48%, the 3-7 year index gained 0.79%, the7-12 year index lost 0.01% and the 12+year index lost 0.66%.

For the year The All Bond index gained 0.64%.

September saw global bond yields move lower as the strongly anticipated September start to tapering by the Federal Reserve Bank of its monthly asset purchases failed to materialise. However, the position was turned on its head in October as a combination of improved US economic data releases and data revisions indicated that the American economy was indeed recovering faster than expected, as well as a temporary resolve on the US Budget Debt ceiling negotiations was achieved. US 10 year yields consequently rose to end the year at 3.00%.

South African bond yields mirrored this general pattern as broad based Dollar strength and a rotation away from emerging markets affected domestic yields. October's lowest lev-els on the liquid R186 Government bond(maturing 2026) were down at 7.64% and the Rand at 9.72 per Dollar, before both markets moved higher in tandem ending the year with R186 yields at 8.30% and the Dollar priced at R10.57. SA CPI returned to within the 3-6% target range, reaching 5.3% in November. The last Monetary Policy Committee for 2013 surprised the market with a more concerned and generally more hawkish commentary. The MPC subtly reinforced its commitment to the broader inflation target mandate citing the weaker Rand as a major risk to the inflation outlook. When it emerged that the only discussed monetary policy options were of main-taining the level of current rates or a pre-emptive rate hike, a firmer message had been relayed to markets regarding fu-ture policy direction should the inflation outlook worsen.

We believe that there are very real risks facing SA bonds for 2014, given the expected tapering by the US Federal Re-serve, risks from rising inflation and the volatility of the Rand. We are cautious and as such will be underweight bonds and short duration relative to the index. We believe there will be increased volatility on returns for the quarter ahead.