Chart 1: Developments in the major fixed income markets in 2005. Yields on 10-year government securities. Per cent per year

Source: Bloomberg

In a number of countries, central banks increased key rates during the year. In the US, the Federal Funds rate was increased by 2 percentage points, whereas the European Central Bank increased the key rate by 0.25 percentage point. The Bank of Japan kept its key rate unchanged, while the Bank of England lowered its key rate by 0.25 percentage point in 2005.

Chart 2 shows changes in value in the Lehman Global Aggregate government bond indices in 2005. In 2005, the return was 2.8 per cent in the US, 6.1 per cent in Europe and 2.1 per cent in Asia.

Chart 2: Movements in Lehman Global Aggregate's government securities indices in the main markets in 2005 (31.12.2004 = 100)

Source: Lehman Brothers

An increase in short-term key rates normally implies that long-term interest rate levels will also rise. This is because key rates are usually increased because inflation is expected to rise. Inflation measured by consumer price inflation rose in most countries in 2005 as a result of higher metal and energy prices. Core inflation (consumer prices excluding energy and food), however, was stable in the largest economies during the year. Wage growth in the US and Japan accelerated but was nevertheless low from a historical perspective. In Europe, and particularly in Germany, substantial restructuring and employers' demands for greater flexibility put a damper on wage growth.

Globalisation of production and trade has increased steadily in recent years. An increasing share of consumer goods is being manufactured in Asia. Prices for such goods have not increased substantially in spite of more than 10 per cent wage growth in a country like China in 2005. Cost-effective production combined with more efficient distribution through e.g. the Internet has contributed to sustaining low prices on a range of products. Increasing use of IT has made it possible to rationalise the production of physical goods, and it has also facilitated the transfer of a number of service industry functions to countries such as India.

Globalisation has had a dampening effect on wage growth, core inflation and global bond yields. At the same time, increasing trade surpluses in China and oil-producing countries have contributed to keeping bond yields low. A large portion surpluses in Asia has been returned to the US primarily through the purchase of bonds issued by American institutions.

Chart 3: The difference between yields on corporate bonds* and Treasureries (credit spread) US in 2005. Basis points

* Companies with credit rating AAA from Standard&Poor's
Source: Lehman Brothers

The yield spread between corporate bonds and government bonds has not changed considerably in 2005 as a whole. The spread narrowed until March and then widened markedly in April. The widening of the yield spread from March to April was a result of the deteriorating financial positions of the two major US car manufacturers, Ford and General Motors (GM). This led to market speculations that credit rating agencies would downgrade these companies.

GM was subsequently downgraded and a number of market participants with positions in debt instruments incurred substantial losses. This led to expectations that more investors would choose to sell the lowest rated securities to avoid further losses. During the second half of the year, developments in the yield spread were more stable.

Chart 4: Individual countries' contributions to fixed income returns 2005. Measured in terms of the currency baske. Per cent

Chart 4 shows how contributions to the fixed income return measured against the currency basket are spread across the currencies in which the Fund is invested. Investments in the US made the largest positive contribution, due in part to the appreciation of the USD against the other currencies in the basket during the year. Contributions from the other currency areas were small. Investments in Japan and the euro countries made the largest negative contributions.

Chart 5: The return on the Fund's fixed income benchmark. 1980-2005. Measured in terms of the currency basket. Per cent per year

Chart 5 illustrates returns in fixed income markets each year since 1980. During this period, the average return was 8.8 per cent per year. The return was 3.5 per cent in 2005.

Early in the 1980s, inflation rates and interest rates were unusually high. In recent years, both inflation rates and interest rates have been considerably lower, which explains why nominal returns on fixed income instruments have been lower in recent years than they were early in the period.

3.2 Management of the fixed income investments

The market value of the Fund's fixed income portfolio rose from NOK 600 billion to NOK 817 billion in 2005. NOK 171 billion in new capital was transferred to the portfolio during the year. Positive returns on the fixed income portfolio contributed NOK 25 billion, while a weaker Norwegian krone in relation to the investment currencies increased the portfolio's market value by NOK 21 billion.

At the end of 2005, about 91 per cent of the fixed income portfolio was managed internally by Norges Bank. Internal management's share of total risk-taking was lower, however, at about 75 per cent. This is because the majority of the external fixed income mandates are managed actively and have a high risk profile.

There are two types of management. One is indexing and active management that is directly related to the indexing task. The objective of this enhanced indexing is to maintain a portfolio that is very close to the benchmark, while taking advantage of special pricing situations to achieve an excess return. Three sub-portfolios are indexed: government guaranteed bonds, corporate bonds and securitised bonds. Two of the sub-portfolios are indexed internally, while the indexing of securitised bonds in the US is managed externally.

Both internal and external managers are engaged in active management which follows an investment philosophy based on specialisation and delegation of decision-making. A group structure has been established to achieve the objective of specialisation. Each group is assigned a mandate with a limited investment universe. The group is specialised to achieve effective utilisation of risk. In practice, this is not enough to achieve profitability because both the quality (information ratio) and the scaling possibilities vary between groups. Profitable management requires effective diversification, dynamic risk allocation between groups (in relation to information advantages) and critical review of scaling issues.

In fixed income management, the main distinctions are between micro and macro positions and the degree of credit risk. This is reflected in the fixed income management group structure, both internally and externally. Thus far, the micro strategies (relative value strategies) have achieved the best results, relatively speaking. However, there are definite scaling limitations here. Due to a desire to maximise income rather than the information ratio (IR), a large portion of the universe is utilised even though quality (measured as IR) varies.

Each manager in the group receives a risk limit. There is very little overriding coordination of positions and there is no overriding market view that restricts the positions in the portfolio. All positions may be attributed to one owner.

In 2005, the hit rate was generally very high at the group, mandate and personal level. This more than outweighed the relatively conservative risk-taking through the year and is consistent with previous experience marked by high quality and moderate risk-taking.

Since 1999, total gross excess return in the fixed income portfolio amounted to NOK 8.9 billion. Of this 24 per cent, or NOK 2.1 billion, represents the contribution from external managers. Until end-2005, 80 per cent of the specialist units, both external mandates and internal groups, had achieved positive results since start-up.

An important element of the investment strategy is to diversify among many independent positions. Norges Bank achieves this diversification by selecting independent specialists, both internally and externally. At the end of 2005, there were 35 specialist mandates within fixed income management, eight of which were internal. In 2005, six new external mandates were assigned and a separate internal mandate was established to manage inflation-linked bonds.

Norges Bank considers the choice of external managers to be an investment decision, where different mandates receive capital allocations or are terminated on the basis of analyses of liquidity and expected future excess returns. At the end of 2005, Norges Bank had 27 different externally managed mandates. The majority of these are regional specialist mandates.

The return on the fixed income portfolio in 2005 was 3.82 per cent measured in terms of the currency basket (cf. Table 13). The return was negative in the third quarter, but positive in the other three quarters.

The fixed income management outperformed the benchmark every quarter of 2005. Total return on the fixed income portfolio was 0.37 percentage point higher than the return on the benchmark portfolio. About 20 per cent of the excess return was attributable to external management, while approximately 80 per cent was attributable to internal management in Norges Bank. The total contribution was roughly NOK 2.5 billion in 2005.

The return figure includes income from securities lending but has not been adjusted for costs in connection with the investment of new capital in the markets.

Table 13: Fixed income returns for each quarter and for the year 2005. Per cent

Chart 6: Movements in the FTSE equity indices in the main markets in 2005 (31.12.2004 = 100)

Source: FTSE

Within individual industrial sectors, US companies by and large recorded the weakest developments, whereas Japanese companies were generally the best performers. Financial sector developments were especially weak in the US compared with Europe and Japan. This was also the case for industrials where prices for Japanese companies rose, while the rise in prices for US companies was sluggish. Developments in the car sector were solid in Japan and Europe in spite of a surge in oil prices. The value of US auto stocks, i.e. primarily Ford and GM, fell during the year. The weak developments reflected a loss of market shares to Japanese car manufacturers in particular.

Table 14 shows that developments were positive in most of the main sectors in 2005. Developments were strongest in the resources sector, whereas developments were more sluggish in non-cyclical services such as telecommunications.

Table 14: Performance of the FTSE Equity World Index in 2005. measured against USD and the Fund's currency basket. Per cent

Developments in the equity markets in Eastern Europe, Russia, the Middle East, South Africa and Latin America were strong in 2005. Many of these markets are dominated by companies in the energy and metals sector. Equity prices for such companies rose sharply as a result of higher prices for oil, natural gas, coal and metals.

In spite of strong demand for consumer electronics and a global upswing in corporate investment, equity price developments in the IT sector were weak in 2005. Developments were stronger in Asian IT companies than in US and European IT companies. One explanation for this is that Asian companies are more heavily exposed in rapidly expanding sectors such as flat TV and PC screens based on LCD or plasma technology. Developments in equity prices for European and US telecom companies were weaker than for similar companies in Eastern Europe, Latin America and Asia. This is partly due to the general improvement in these countries' economies in 2005, but is also because telecom services are far less prevalent in these countries than in developed countries.

Chart 7: The FTSE All-World Equity Index 1998-2005: Total and for the technology, media and telecommunications (TMT) sector. (31.12.1998 = 100)

Source: FTSE

Chart 7 illustrates the significance of the technology, media and telecommunications (TMT) sectors for the equity indices over the last seven years. Equity prices in the TMT sectors rose sharply from 1999 until early summer 2000 and then fell to one-fourth of its peak level. Developments in equity prices in the TMT sectors have been somewhat weaker than developments in the other sectors in the FTSE All-World Equity Index in 2004 and 2005.

Chart 8: The individual countries' contributions to equity returns measured in terms of the currency basket in 2005. Per cent

Chart 8 shows the various markets' contributions to the return on the Fund's equity portfolio in 2005 measured against the currency basket. The US, the euro countries and the UK made the largest positive contributions.

Chart 9: The return on the Fund's equity benchmark. 1980-2005. Measured in terms of the currency basket. Per cent

Chart 9 shows returns in the equity market each year since 1980. During this period, the average return was 14.5 per cent per year. The return in 2005, 20.3 per cent, was thus considerably higher than average for the entire period.

4.2 The Fund's equity investments

The market value of the equity portfolio increased from NOK 416 billion to NOK 582 billion in 2005. NOK 50 billion in new capital was transferred to the portfolio during the year. Developments in equity markets were strong and the return on the equity portfolio contributed NOK 101 billion. A weaker krone in relation to the investment currencies increased the portfolio's market value by about NOK 15 billion.

In 2005, the excess return on externally managed portfolios was 4.0 per cent. Compared with the annual excess return of 1.0 per cent achieved since 2000 and with Norges Bank's objective for this portion of asset management, the year's excess return was very high. The percentage excess return was higher only once, in 1999. The contribution in 2005 amounted to roughly NOK 7 billion. Since Norges Bank began using external active managers at the end of 1998, gross contribution from externally managed portfolios has totalled approximately NOK 13 billion. 68 per cent of the externally managed portfolios reported positive results in 2005, the same percentage as in 2004. During the three-year period 2003-2005, 80 per cent of the externally managed portfolios had an excess return. This was the case for mandates established more than three years ago as well as for newer mandates. In 2005, average excess return on mandates with positive figures was 2.3 times higher than the average underperformance on mandates with negative figures, whereas in 2004 they were the same.

An important element of the strategy behind the choice of external managers is to diversify among many independent positions. Norges Bank achieves this diversification by selecting many independent specialists each of whom builds up their portfolio primarily by means of fundamental analysis of individual stocks.

All external equity mandates have their own benchmarks and risk limits. The regional mandates have benchmark portfolios that are composed of the companies in the FTSE index in a geographic region, such as Continental Europe, the UK, the US and Japan. The sector mandates have benchmark portfolios in business sectors such as finance, technology, healthcare, oil and gas, utilities, retail trade, media and telecommunications. In the last couple of years, Norges Bank has increased the share of specialist mandates in industry sectors, and these mandates account for 28 per cent of the external management. In 2005, mandates in Asia excluding Japan were split up and assigned to managers specialising in specific countries and smaller regions. With a combination of specialist mandates, there will be more different equity positions than with overlapping broad mandates. This in turn increases the number of independent positions in the externally managed portfolios.

At the end of 2005, Norges Bank had 43 different externally managed equity portfolios. Of these, 28 represent regional and specific country mandates and 15 represent specific industry sectors. Average market value is somewhat higher for the regional mandates (NOK 5.5 billion) than for the sector mandates (NOK 4.1 billion). At year-end, 37 per cent of the equity portfolio or NOK 217 billion was under external management.

Norges Bank considers the choice of external managers to be an investment decision, where different mandates receive capital allocations or are terminated on the basis of analyses of liquidity and expected future excess returns. Approximately 10 per cent of the mandates are terminated each year. The most common reason is that the portfolio manager responsible for Norges Bank's portfolio has terminated his employment. In 2005, the share of mandates that were terminated was higher than usual. This was due to the fact that a number of portfolio managers had terminated their employment with the company in question and that mandates were split up into smaller specialist mandates.

At the end 2005, more than 60 per cent of the equity portfolio was managed internally in Norges Bank in an enhanced index portfolio. The rest of the internal active management has been built up gradually over the last few years and currently comprises 22 portfolio managers who use fundamental analysis strategies to pick stocks in the industry sectors finance, telecommunications, energy, media and retail trade globally, as well as relative value strategies. The organisation of internal asset management was changed considerably in 2005 and all managers are currently managing within a long-short portfolio framework. This means that each manager borrows shares from the internal index portfolio or in the market. Thus, there is further specialisation among active strategies and indexing and internal financing. It is not necessary for Norges Bank to choose between internal and external active management since the internal active positions do not lay claim to the assets under management.

Norges Bank's internal management contributed about 25 per cent of the total excess return on the equity portfolio. However, these figures do not take into account internal managers' transaction costs in connection with the transfer of new capital to the Fund, restructuring of portfolios or changes in the benchmark portfolio.

At the beginning of the year, the internal portfolio accounted for less than 20 per cent of the equity portfolio's total risk. At the end of the year, the share had increased to more than 30 per cent. The annual average was 23 per cent. In 2005, 86 per cent of the internal mandates achieved a positive excess return, somewhat less than in 2004 when all internal mandates achieved a positive excess return. The solid performance is also due to the fact that the average excess return was 4.3 times higher than the average underperformance.

Table 15 shows that the return on the equity portfolio measured in terms of the Fund's currency basket was 22.49 per cent in 2005. The return was positive during all quarters of the year, but was especially high in the fourth quarter. This largely reflects general price movements in equity markets through the year.

The actual return on the equity portfolio was 2.24 percentage points higher than the benchmark return. Nearly half of the excess return was achieved during the fourth quarter. The total contribution from equity management in 2005 was roughly NOK 9.5 billion.

Table 15: The return on the equity portfolio for each quarter and for 2005 as a whole. Per cent

Chart 10: Voting in 2005 / Regional distribution 2005

Number of resolutions

Norges Bank voted on 20 307 resolutions at 2 705 General Meetings. It is possible to vote for, to vote against or to abstain on individual resolutions. Voting on one resolution implies that we must vote on all resolutions on the agenda. The corporate management submits the majority of resolutions, but shareholders can also submit proposals. Somewhat more than 3 per cent of the proposals on which we have voted were shareholder proposals. Shareholder proposals are very common in the US, relatively common in Japan but more unusual in Europe. Norges Bank has voted against 9 per cent of the management proposals and has supported 41 per cent of the shareholder proposals.

The various matters to be voted on at General Meetings may be divided into seven categories as shown in Chart 11.

Chart 11: Voting 2005 / voting issues

Nearly 50 per cent of the matters are Directors related and are related to the election of board directors and to the structure of the board. 23 per cent of the matters are routine issues and are categorised under Routine/business. They include changes in the articles of association, approval of accounts, annual report and dividends as well as approval of auditors and their fees. 11 per cent of the matters are related to bonuses and remuneration plans in the form of equity instruments and are categorised under Non-salary compensation. Ten per cent of the proposals are included under Capitalisation, while four per cent fall under Reorganisation and mergers, which includes proposals concerning the General Meeting's approval of acquisitions and mergers. Three per cent are shareholder proposals and less than one per cent are Anti-takeover mechanisms which are issues related to various mechanisms that may be used by companies to make it more difficult for other companies to acquire them.

Voting against management

In 2005, Norges Bank voted against management proposals on 1 815 resolutions. Norges Bank supported the management's proposal on 91 per cent of the resolutions, which is natural because in most cases the Bank has confidence in the way the company is run.

51 per cent of the cases where we have voted against the management have been in companies in Asia/Oceania, more than 40 per cent have been in companies in the Americas and the remaining nine per cent have been in companies in Europe. We voted against eight per cent of the management's proposals in the Americas, three per cent in Europe, and 14 per cent in Asia/Oceania.

Norges Bank has voted against the management's proposal in the following cases:

Routine/business

In a number of cases, especially in Japan, we have voted against the proposed auditor due to a strong conflict of interest and lack of independence. Norges Bank voted against a proposal in the US to prohibit cumulative voting which allows shareholders to cast all of their votes for a single board candidate.

Directors related

In a number of US and Asian companies, Norges Bank abstained or voted against the board candidate proposed by management because independent board members have not been in the majority and because board members who are not independent are on important board committees (nominating, remuneration and auditing). In US companies, you can either support the candidate proposed by management or withhold. This means that a candidate may be elected with only one vote and that the shareholders have little real influence on the election of board members.

In many US companies, Norges Bank has voted against re-election of the chairman of the board when he or she is also the company's CEO. Norges Bank withheld votes for board members who have been on the board remuneration committee in cases where the CEO has received an excessive pay increase at the same time as the company has performed poorly, both in the short and long term. The Bank has also voted against the re-election of board members who have not participated sufficiently in board work without good cause. In some cases, the Bank has voted against the re-election of board members in US companies who for a number of years have disregarded shareholder proposals to remove poison pills (a widespread mechanism against takeovers, see below and see article on shareholder rights to be published on Norges Bank's website in March) or to introduce annual elections of all board members. The proposals mentioned here have been submitted several years in a row and been supported by a majority of those voting at the General Meeting.

Non-salary compensation

Most of the remuneration-related proposals that Norges Bank voted against involved option plans. Norges Bank voted against option plans that were not performance related or that led to relatively large dilution of existing share-holders' ownership interests. The Bank voted against pension bonuses for board members and auditors. The Bank also voted against compensation plans in cases where background information was inadequate.

Capitalisation

Norges Bank voted against proposals for issues of shares that would significantly dilute existing shareholders' ownership interests. In European companies, the Bank voted against proposals to buy back shares in cases where the offer was only made to some of the shareholders. At the General Meetings of many Hong Kong companies, we have voted against issues of shares where the offer was made to a small group of shareholders at a very favourable price. At a number of French General Meetings, the Bank did not support proposals concerning rights issues that were only offered to shareholders who had owned shares for more than two years. In Japa nese companies, Norges Bank voted against dividend proposals that were considered to be too low in relation to earnings. The Bank also voted against issues of shares in cases where the shareholders did not receive adequate information.

Reorganisation and mergers

In several Brazilian companies, the Bank voted against takeover proposals in cases where the shareholders had received inadequate information. In a European company, the Bank voted against a proposal to remove the mandatory bid obligation that is triggered when an investor buys more than one-third or one-half of a company. The mandatory bid obligation is intended to protect the minority shareholders who have little influence on how the company is managed in companies with a dominant owner. It is also intended to ensure that minority shareholders are offered a fair price for their shares. In a number of Korean companies, the Bank voted against expanding the company's activities due to inadequate information.

Anti-takeover mechanisms

Norges Bank has voted against proposals to change companies' articles of association in order to discontinue the practice of annual elections of board members. The Bank has voted against proposals to give the board a general power of attorney to issue shares in the event of a takeover bid, so-called poison pills, which makes it less attractive to acquire a company. Many such proposals have been made at Japanese companies' General Meetings as a result of a change in Japanese law which now permits takeovers in the form of share swaps. Previously, foreign takeovers of Japanese companies have been unusual because a takeover required cash settlement, but with the new legislation, one may expect that there will be an increase in foreign takeovers.

Table 17: Voting 2005 / Against the management

Shareholder proposals

Shareholder proposals are normally not supported by the management. Therefore, a vote in favour of such a proposal is often a vote against management. In 2005, shareholder proposals accounted for more than 3 per cent of the resolutions on which Norges Bank voted. Such proposals are most common in the US. They are less common in Japan and very rare in Europe. At General Meetings where we voted, Norges Bank supported 41 per cent of the shareholder proposals.

Shareholder proposals are a heterogeneous group. At the one end of the spectrum, we find large, institutional investors, like pension funds, who act and vote on the basis of established ownership principles. At the other end, we find individuals with a small number of shares and who may have special interests underlying their initiatives.

Shareholder proposals are primarily related to protecting shareholder rights, to board issues and to management remuneration, but they may also concern social and environmental issues. The topics of the latter proposals are often very relevant, but in many cases Norges Bank does not support proposals because of the manner in which they are formulated or because of their demands on the company. The company's management may already have dealt with the issues in a more appropriate manner or we believe that shareholders may not benefit from approving such proposals due to their form, seriousness, feasibility and financial consequences. This means that even though Norges Bank voted against many of the proposals, the Bank is not necessarily against promoting these issues, and in many cases the Bank will be able to promote such issues more effectively through other corporate governance activities.

Norges Bank has voted in favour of shareholder proposals that demand:

• equal voting rights for all shares
• that the CEO cannot be the chairman of the board
• that the General Meeting must approve any anti-takeover mechanisms and excessive golden parachutes and severance agreements
• that shareholders may propose board candidates under certain conditions
• that options must be expensed
• that the allocation of options must performance-related
• that the majority of the board members must be independent
• that all board members must run for re-election each year
• that the compensation to senior executives is made public in the annual report
• that more companies with operations in countries where human rights are traditionally not respected, and where the companies historically have not published sufficient details about their human rights policies, develop ethical guidelines relating to human rights and submit reports on their compliance with these guidelines
• that a number of major food retailers report on their economic, social and environmental impact (triple-bottom-line accounting)
• that the companies report on their guidelines for equal rights for all employees
• that a number of major oil companies report on their compliance with the Kyoto Protocol

Chart 12: Absolute market risk in the Government Pension Fund - Global. Month-end. Per cent

At year-end, the value of the actual portfolio was NOK 1 399 billion. Given the estimated absolute tracking error at the end of the year, returns in two out of three years may be expected to be either 7.4 percentage points higher or 7.4 percentage points lower than the expected market value of the Fund. Converted to NOK, assuming no transfers and including expected historical returns, this means that with 68 per cent probability, the value of the Fund in one year will be between NOK 1 380 billion and NOK 1 600 billion, assuming an expected nominal return of 6.5 per cent.

Absolute market risk is largely determined by the Fund's benchmark portfolio. The Ministry of Finance has also set a limit for expected tracking error which limits how much the Fund's portfolio can differ from the benchmark portfolio. This expected tracking error shall always be less than 1.5 percentage points (150 basis points, see box). Chart 13 shows that the expected relative tracking error in 2005 has been relatively stable for both the total portfolio and for the fixed income and equity portfolios individually. At the end of 2005, it was 0.33 per cent for the total portfolio.

Chart 13: Expected tracking error at each month-end in 2005. Basis points

6.2 Credit risk

Credit risk arises in the Fund's fixed income portfolio partly as a result of the Ministry of Finance's investment strategy and partly as a result of Norges Bank's active management (credit portfolio risk). In both the equity and fixed income portfolios, Norges Bank is exposed to counterparty risk, risk vis-à-vis custodian institutions, and risk vis-à-vis international settlement and payment systems (operational credit risk).

The Ministry of Finance has established guidelines for credit risk in fixed income instruments, unsecured bank deposits and for counterparties in unlisted derivatives transactions (forward contracts, options and swaps, etc.) These guidelines assume that the credit rating is based on ratings from at least one of the three international credit rating agencies Fitch, Moody's or Standard & Poor's (S&P).

The Ministry of Finance has decided that the portfolio shall not be invested in fixed income instruments with a credit rating that is lower than investment grade, i.e. BBB, Baa or BBB from Fitch, Moody's or S&P respectively. Nevertheless, up to 0.5 per cent of the fixed income portfolio may be invested in securities with ratings of Ba, BB or BB from one of the three agencies. Table 18 shows the composition of the bond portfolio (total fixed income portfolio excluding cash) based on Moody's and S&P credit ratings. All fixed income securities have a credit rating from at least one of the agencies.

In addition to bonds, the fixed income portfolio also contains fixed income instruments with shorter maturities. All of these have credit ratings of P-1 from Moody's and A-1 from S&P.

The equity and fixed income portfolios also include investments in unsecured bank deposits and over-the-counter derivatives. The Ministry of Finance has decided that counterparties involved in such transactions may not have a credit rating that is lower tha AA-/Aa3/AA- from Fitch, Moody's or S&P respectively.

Table 18: The bond portfolio at 31 December 2005. by credit rating. Per cent of market value

* If a security has no rating from Moody's. it has an approved rating from one of the other agencies (S&P or Fitch).

6.3 Operational risk

Market risk and credit portfolio risk are important factors when establishing an investment strategy and in active management. The objective is to achieve the highest possible risk-adjusted return and not necessarily the lowest possible risk. On the other hand, operational risk is an intrinsic risk where the objective is the lowest possible risk, given the operating conditions inherent in being an international asset manager. It is more difficult to quantify operational risk than market risk and credit portfolio risk.

Operational risk cannot be isolated from market and credit portfolio risk, but it is more comprehensive and affects the entire organisation. Important elements of operational risk originate in the choice of counterparties that handle transactions and in custody and clearing of securities in international and local settlement and clearing systems. Norges Bank has initiated measures to ensure that this risk is low. These measures include procedures for approving central counterparties, including credit ratings, and legal quality assurance of all contracts.

Operational risk also arises in connection with identification and assessments related to the selection of IT systems, legal agreements with external service providers, the fund management organisation, loss of key personnel, review and maintenance of contingency plans, etc.

Norges Bank places considerable emphasis on managing operational risk. This is seen in relation to the Bank's principles and guidelines for internal control of operations. The Bank has decided that Kredittilsynet's (Financial Supervisory Authority) Regulation on internal control in financial institutions shall be followed and the Bank's management system has been adapted accordingly. Internal control is a collective term for all measures, schemes, systems etc. that are initiated to ensure that established objectives at all levels of business operations are achieved. Important aspects of Norges Bank's internal control include annual risk analyses to identify significant risks in connection with business activities, the need to initiate necessary measures, assessment of the control environment (i.e. culture and attitudes) as well as reporting and follow-up.

6.4 Fund management guidelines

The Ministry of Finance has established a number of guidelines for the management of the Government Pension Fund - Global. Table 19 summarises the risk and exposure limits stipulated in the regulation on the management of the Fund. The table shows that exposures at the end of each quarter were within the established limits.

In 2005, there were no significant breaches of the guidelines established by the Ministry of Finance. There were three minor breaches, one of which was in the fourth quarter. An external manager invested in a credit swap where the underlying collateral was a Norwegian company. The investment was small and the position was unwound.

Table 19: The regulation's risk and exposure limits

* In addition to ordinary bank deposits, reinvested cash collateral is included in the table