## _041406i

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---

### I. Overview and Institutional Authority
- Purpose: Summarizes considerations and presents decisions for establishment of an Investment Account (IA).
- Legal authority:
  - Fund’s Articles of Agreement authorize establishment of an IA whose income may be used to meet the expenses of conducting the business of the Fund.
  - The total amount that may be transferred to the IA is equivalent to the Fund’s general and special reserves at the time of the decision to make the transfer.
- Reserves at issue:
  - Reserves projected to total SDR 5.9 billion at the end of the current fiscal year.
- Rationale:
  - Investing currencies equivalent to accumulated reserves aligns Fund practice with other financial institutions.
  - Proposed strategy: invest in a portfolio of fixed income securities consistent with Articles limits and similar to PRGF and HIPC approaches.
  - Expected outcome: extension of maturities beyond the three-month SDR interest rate would generate incremental income over time with inevitable volatility; broadens income sources and contributes to financial resilience.

### II. Steps to Establish the Investment Account
- Required Executive Board decisions:
  - (i) Decision to establish the IA — may be taken by a majority of the votes cast.
  - (ii) Decision to adopt the rules and regulations of the IA — may be adopted by a 70 percent majority of the total voting power.
  - (iii) Decision to transfer to the IA for immediate investment currencies held in the GRA — may be adopted by a 70 percent majority of the total voting power.
- Member concurrence:
  - Concurrence of members whose currencies will be used to make investments is required.
- Funding mechanism:
  - Funding through transfer of currencies from the GRA effected within the Financial Transactions Plan (FTP).
  - Quarterly FTP set to accommodate transfer equivalent to Fund’s general and special reserves, projected to amount to SDR 5.9 billion at the end of the current fiscal year.

### III. Investment Authority and Eligible Investments
- Legal investment authority (Article XII, Section (6)(f)(iii)):
  - “The Fund may invest a member’s currency held in the Investment Account in marketable obligations of that member or in marketable obligations of international financial organizations. No investment shall be made without the concurrence of the member whose currency is used to make the investment. The Fund shall invest only in obligations denominated in special drawing rights or in the currency used for investment.”
- Currency and FX risk management:
  - Portfolio limited to obligations denominated in SDRs or in currencies included in the SDR basket.
  - Holdings weighted to reflect each currency’s share in the SDR basket.
- Specifically eligible investments:
  - domestic government bonds of countries in the euro area, Japan, the United Kingdom, and the United States;
  - bonds of eligible national agencies and international financial organizations;
  - claims on the BIS, including BIS deposits and medium-term instruments (MTIs).
- Constraints and clarifications:
  - Eligible national agencies are central banks and official agencies of members.
  - Obligations issued by a member in a foreign currency are not eligible; investments must be denominated in SDRs or in the currency used for investment.
  - MTIs are obligations of the BIS whose yield is based on the AA-rated swap yield curve.
  - World Bank and regional development banks specified among eligible international financial organizations.
- Market/instrument limits:
  - Investments only in cash markets; derivatives—including forwards, futures, options and swaps—may not be used to establish or hedge positions.
  - Only long positions permitted; short selling or leverage not permitted.

### IV. Investment Objective, Horizon, and Benchmark
- Investment objective:
  - Exceed the SDR interest rate over time while minimizing the frequency and extent of negative returns and underperformance over a 12-month investment horizon.
- Means:
  - Judicious extension of duration above the three-month SDR interest rate via eligible longer term government bonds and other fixed income securities.
  - Limited scope to benefit from credit spreads largely through MTIs and BIS deposits, and securities issued by eligible international financial institutions and certain national agencies.
- Benchmark candidates and staff recommendation:
  - Benchmarks with efficient tradeoff of risk and return include the 1–3 year and the 1–5 year government bond indices (constructed using Merrill Lynch government bond indices for euro, yen, sterling, and U.S. dollar, weighted to SDR basket currency weights).
  - Preference for the 1–3 year benchmark over 1–5 year benchmark based on:
    - relatively modest increase in ex ante yield from the longer duration in a relatively flat yield curve environment;
    - term premiums above two-year maturities particularly narrow at present;
    - 1–3 year sector favored by reserve asset managers;
    - shorter duration prudent given possibility of further increases in yields.

### V. Risk Controls
- Main risks:
  - Interest rate risk (primary), credit risk (mainly via MTIs), residual currency risk, operational risk.
- Interest rate risk control:
  - Controlled by the duration of the benchmark indices selected; 1–3 year benchmark selected as acceptable level of interest rate risk consistent with investment objective.
  - Tactical benchmark changes may be considered exceptionally to control loss risk in unusually volatile markets; decisions based on periodic market evaluations assessing probability of loss over a 12-month horizon, yield levels and spreads, and yield volatility.
- Currency risk control:
  - Securities denominated in SDR constituent currencies; currency weights adjusted to reflect SDR basket; regular rebalancing required to manage residual currency risk.
- Liquidity and credit risk:
  - Liquidity risk judged small given low likelihood of unanticipated calls on IA assets and inherently liquid portfolio composition.
  - Credit risk limited via BIS deposits, MTIs, securities of highly rated international financial organizations, and domestic government bonds of SDR basket countries.
  - Eligible securities limited to those rated A or higher by a major credit rating agency such as Standard and Poor’s, Moody’s, or Fitch.
- Operational risk mitigation:
  - Due diligence reviews of external managers and custodians; reconciliation of portfolio valuation; stringent performance measurement and reporting; internal controls; policies complementing the Fund’s Code of Conduct.
  - Controls to mitigate conflicts of interest; Finance Department staff guided by policies on material non-public information, disclosure requirements for conflicts, and financial disclosure requirements.

### VI. Administrative Arrangements
- Management approach:
  - Use existing administrative arrangements for investments; external asset managers—including the World Bank and private managers—will buy and sell individual securities consistent with IA authority, guidelines, and benchmark.
  - Staff will place deposits with the BIS and structure a portfolio of MTIs.
- Manager mandates and reporting:
  - External managers receive mandates consistent with IA rules and objectives; each manager assigned the 1–3 year government bond index as benchmark.
  - Managers permitted limited deviation from benchmark duration to add value.
  - Reporting: monthly valuations; detailed quarterly reports on portfolio structure, sources of return, and investment prospects.
- Custody and valuation:
  - MTIs and BIS deposits held in custody by the BIS; government bonds and eligible securities remain with current custodian.
  - Custodian responsibilities include safekeeping, trade settlement, income capture, asset valuation, record maintenance, performance measurement, compliance monitoring.
  - Daily portfolio valuation with full reconciliation of manager and custodian mark-to-market valuations each month; custodian to sweep idle cash into short-term fund consistent with IA authority.

### VII. Reporting and Audit
- Semiannual reporting:
  - Semiannual reports to the Executive Board on IA operations in context of the Fund’s overall financial position, including contribution to Fund income.
  - Reports to include analysis of changes in valuation of IA assets, investment guidelines and benchmark followed by asset managers, evaluation of adequacy of risk control procedures, and assessment of market conditions affecting IA valuation.
- Ad hoc reporting:
  - Ad hoc reports to the Executive Board as warranted by market or other developments.
- Audit:
  - IA assets audited by the Fund’s external auditors and included in the Fund’s financial statements.

### VIII. Proposed Decisions and Implementation
- Proposed Executive Board decisions:
  - Decision 1: Establishment of the Investment Account — may be adopted by a majority of the votes cast.
  - Decision 2: Adopt rules and regulations for administration of the IA set out in Annex I — may be adopted by a 70 percent majority of the total voting power.
  - Decision 3: Transfer of currencies from the GRA to the IA — may be adopted by a 70 percent majority of the total voting power.
- Implementation specifics (Decision No. 3):
  - Transfer from the General Resources Account to the Investment Account currencies in an amount equivalent to the amount of the Fund’s general and special reserves at April 30, 2006.
  - The transfer shall be effected in the context of the Financial Transactions Plan for the quarterly period March through May 2006 and June through August 2006.
  - Currencies transferred to be used for immediate investment in accordance with Article XII, Section 6(f) and the Rules and Regulations adopted pursuant to Decision No. 13711-(06/40).

### Annex II — Analytical Findings (Historical risk/return, VaR, stress tests, prospective returns)
- Historical risk and return (Jan. 1989–Feb. 2006):
  - Extending maturity increases average annual return but also increases dispersion of returns.
  - Since 1989, each bond portfolio considered outperformed the three-month SDR interest rate.
  - Average annual excess return (1989–2006) by maturity:
    - Six-month portfolio: 0.10 percent
    - 7–10 year portfolio: 3.30 percent
  - Intermediate portfolios (1–3 year and 1–5 year) show significantly higher Sharpe ratios than the six-month SDR rate.
  - Portfolios with maturity of 1–5 years or lower: have not experienced negative returns in any rolling one-year period since 1989.
  - Return shortfall versus the three-month SDR rate occurred in about 23 to 28 percent of rolling one-year horizons (Jan. 1989–Feb. 2006); frequency similar across maturities but magnitude of underperformance increases with maturity.
- Value-at-risk (VaR) and stress tests (capital = SDR 1 billion) — Annual VaR by historical performance (1989–2006) — Average Return, Standard Deviation, 95% VaR, 99% VaR (In percent / In millions of SDR):
  - 6 M: Average Return 4.54, Standard Deviation 2.05, 95% 12, 99% -2
  - 1–3 Y: Average Return 5.68, Standard Deviation 2.66, 95% 13, 99% -5
  - 1–5 Y: Average Return 6.15, Standard Deviation 3.12, 95% 10, 99% -11
  - 3–5 Y: Average Return 6.81, Standard Deviation 3.87, 95% 4, 99% -22
  - 7–10 Y: Average Return 7.86, Standard Deviation 5.70, 95% 0, 99% -54
  - Interpretation: 1 percent chance that in any year the 1–3 year portfolio of SDR 1 billion could lose more than SDR 5 million (0.5 percent of its value).
- Stress test (1- and 2-standard-deviation increases in two-year government yields; capital = SDR 1 billion):
  - 1–3 year portfolio:
    - Instantaneous average return: 3.71 percent
    - Average duration: 1.7
    - Expected Annualized Return with a 1 Standard Deviation shock: 1.60 percent
    - Instantaneous capital loss (SDR millions): -23
    - Capital loss as percentage: -2.3
    - Expected Annualized Return with a 2 Standard Deviation shock: -0.62 percent
    - Instantaneous capital loss (SDR millions): -45
    - Capital loss as percentage: -4.5
  - 1–5 year portfolio:
    - Instantaneous average return: 3.77 percent
    - Average duration: 2.5
    - Expected Annualized Return with a 1 Standard Deviation shock: 0.63 percent
    - Instantaneous capital loss (SDR millions): -33
    - Capital loss as percentage: -3.3
    - Expected Annualized Return with a 2 Standard Deviation shock: -2.64 percent
    - Instantaneous capital loss (SDR millions): -67
    - Capital loss as percentage: -6.7
  - Note: Standard deviation calculated on daily returns since January 1, 1992.
- Investment horizon effects:
  - Frequency of negative returns and underperformance declines with longer horizons.
  - 1–3 year portfolio: negative returns in 3 percent of rolling 3-month periods (Jan. 1989–Feb. 2006); no negative performance in any rolling six-month or one-year period.
  - No portfolio experienced a loss in any rolling two-year period.
  - Rolling semiannual periods: bond portfolios underperformed in about 30 percent of cases; rolling quarterly: underperformed in about 37 percent of cases.
- Current interest rate environment (data through Feb/Mar 2006) — four features:
  - Yields increased since mid-2003 trough but remain below 1989–2006 averages; prospective coupon income likely lower than historical averages; current yield volatilities below 1989–2006 averages.
  - SDR yield curve relatively flat; U.S. and U.K. yield curves inverted; low term premium provides little income cushion against further rate increases.
  - Bank of Japan policy change increases risk of rising yields on Japanese government bonds given current very low yield levels.
  - Short-term interest rate futures imply: U.S. (44 percent weight in SDR basket) approaching end of tightening cycle; gradual continuation of tightening in euro area; Japanese yields expected to rise from low levels; U.K. yields priced to remain little changed; synthetic SDR interest rate set to increase by about 20 basis points over the next 12 months.
- Probability of negative returns in the current environment (Table 7, selected values):
  - Yields (in percent): 1–3 year 3.71; 1–5 year 3.77; 3–5 year 3.83; 5–7 year 4.17; 7–10 year 4.15
  - Implied Volatility (in bps): 1–3 year 64; 1–5 year 67; 3–5 year 68; 5–7 year 73; 7–10 year 70
  - Probability of negative returns (in percent): 1–3 year 0.04; 1–5 year 1.07; 3–5 year 5.30; 5–7 year 12.99; 7–10 year 19.42
  - Historical peak ex ante probability for 1–3 year index was 14 percent during 2002–03.
- Diversification into MTIs:
  - MTI characteristics: BIS-issued fixed income security with yield based on swap rates minus a fixed margin; returns from government yield movements and MTI credit spread.
  - Past MTI performance (April 2000–January 2002):
    - 1–3 Year government bonds: Annualized return 6.08 percent, Standard deviation 1.12, Risk-adjusted Return 5.42
    - MTIs: Annualized return 6.65 percent, Standard deviation 1.28, Risk-adjusted Return 5.20
    - Excess return of MTIs over 1–3 year government bonds: 0.57 percent
    - Correlation between MTIs and 1–3 year government bond benchmark: 0.89
  - MTI Sharpe and monthly returns (selected samples):
    - US dollar (Mar 1999–Dec 2005): BIS MTIs Sharpe Ratio 0.70, Monthly Return 0.39; US Treasury 0.53/0.35
    - Euro (Mar 2000–Dec 2005): BIS MTIs Sharpe Ratio 0.76, Monthly Return 0.34; Germany 0.73/0.34
    - Sterling (Nov 1999–Dec 2005): BIS MTIs Sharpe Ratio 0.68, Monthly Return 0.54; UK Treasury 0.49/0.50
  - MTIs appear advantageous in terms of risk-adjusted return; yield spreads broadly in line with long-term average.

### Conclusions and Recommendations
- Historical record (1989–2006):
  - All analyzed bond portfolios generated substantial cumulative excess returns over the three-month SDR rate; excess return increased with maturity while volatility also increased.
  - On a one-year horizon, the 1–3 year portfolio outperformed the 3-month SDR rate in about three quarters of rolling 12-month periods and did not generate negative returns in any rolling 12-month period.
- Benchmark recommendation:
  - Both 1–3 year and 1–5 year bond benchmarks consistent with objective of outperforming SDR interest rate while minimizing risk of loss in any year.
  - Preference for the 1–3 year index given current limited term premium for maturities above two years, wide use by reserve managers, consistent positive rolling 12-month returns over the past 16 years, and low probability of negative returns in current environment.
  - Historical performance metric: during 1989–February 2006, average annual excess return over the three-month SDR interest rate for the 1–3 year benchmark was 111 basis points.
- Implementation caveats and execution:
  - Current tightening monetary conditions, relatively low interest rate volatility, and tight credit spreads mean past bond returns may not reliably predict future performance.
  - Given current yield and volatility expectations, risk of loss is low on a 1–3 year portfolio.
  - Risk could be further mitigated by phasing in bond investments over months rather than investing IA assets in one shot.
- MTIs:
  - Have provided additional return over government bonds and some diversification gains, fairly compensating for small credit risk exposure.

*Source: _041406i*

### 1.      This paper summarizes the relevant considerations and presents decisions for the

### _041406i - 1.      This paper summarizes the relevant considerations and presents decisions for the

### I. Overview and Institutional Authority
- Purpose: Summarizes considerations and presents decisions for establishment of an Investment Account (IA).
- Background:
  - Executive Directors considered an analysis in September 2005; requested a decision paper in March 2006 on medium-term outlook for the Fund’s income.
- Legal authority:
  - Fund’s Articles of Agreement authorize establishment of an IA whose income may be used to meet the expenses of conducting the business of the Fund.
  - The total amount that may be transferred to the IA is equivalent to the Fund’s general and special reserves at the time of the decision to make the transfer.
- Reserves at issue:
  - Reserves projected to total SDR 5.9 billion at the end of the current fiscal year; these are the Fund’s accumulated retained income and have not been invested historically.
  - Historical practice: reserves formed part of currency balances kept with creditor members, reducing remunerated positions and yielding an implicit return equal to the SDR interest rate.
- Rationale for investing reserves:
  - Investing currencies equivalent to accumulated reserves aligns Fund practice with other financial institutions.
  - Proposed strategy: invest in a portfolio of fixed income securities consistent with Articles limits and similar to PRGF and HIPC approaches.
  - Expected outcome: extension of maturities beyond the three-month SDR interest rate would generate incremental income over time with inevitable volatility; broadens income sources and contributes to financial resilience.

### II. Steps to Establish the Investment Account
- Three key decisions required:
  - (i) Decision to establish the IA — may be taken by a majority of the votes cast.
  - (ii) Decision to adopt the rules and regulations of the IA — may be adopted by a 70 percent majority of the total voting power.
  - (iii) Decision to transfer to the IA for immediate investment currencies held in the GRA — may be adopted by a 70 percent majority of the total voting power.
- Member concurrence:
  - It will be necessary to secure the concurrence of the members whose currencies will be used to make investments.
- Funding mechanism:
  - Funding through transfer of currencies from the GRA effected within normal operation of the financial transactions plan (FTP).
  - Quarterly FTP would be set to accommodate transfer equivalent to Fund’s general and special reserves, projected to amount to SDR 5.9 billion at the end of the current fiscal year.
  - A range of participants in the FTP will be drawn upon to fund the IA.

### III. Investment Authority and Eligible Investments
- Legal investment authority:
  - Specified in Article XII, Section (6)(f)(iii) of the Articles; identical to that governing SDA resources.
  - Quoted authority: “The Fund may invest a member’s currency held in the Investment Account in marketable obligations of that member or in marketable obligations of international financial organizations. No investment shall be made without the concurrence of the member whose currency is used to make the investment. The Fund shall invest only in obligations denominated in special drawing rights or in the currency used for investment.”
- Currency and FX risk management:
  - Portfolio limited to eligible obligations denominated in SDRs or in currencies included in the SDR basket, as agreed by Executive Directors in September 2005.
  - Holdings of constituent currencies of the SDR will be weighted to reflect each currency’s share in the SDR basket to minimize residual foreign exchange rate risk.
- Specifically eligible investments:
  - domestic government bonds of countries in the euro area, Japan, the United Kingdom, and the United States;
  - bonds of eligible national agencies and international financial organizations;
  - claims on the BIS, including BIS deposits and medium-term instruments (MTIs).
- Additional operational detail:
  - Uninvested residual cash balances held by external bond managers will be swept by the custodian bank into short-term instruments consistent with the IA’s investment authority.
- Eligibility constraints and clarifications:
  - Eligible national agencies are central banks and official agencies of members.
  - An obligation issued by a member country (or its central bank or official agency) in a foreign currency is not an eligible investment; investments must be denominated in SDRs or in the currency used for investment.
  - MTIs are obligations of the BIS whose yield is based on the AA-rated swap yield curve.
  - The Commentary to the Second Amendment specifies World Bank and regional development banks among eligible international financial organizations.

### IV. Investment Objective and Benchmark
- Primary investment objective:
  - Add value over the implicit current rate of return on the Fund’s reserves while keeping within prudent risk limits.
  - Specifically: exceed the SDR interest rate, while minimizing the frequency and extent of negative returns and underperformance over a 12-month investment horizon.
- Means to achieve objective:
  - Judicious extension of duration above the three-month SDR interest rate via eligible longer term government bonds and other fixed income securities.
  - Limited scope to benefit from credit spreads largely through MTIs and BIS deposits, and securities issued by eligible international financial institutions and certain national agencies.
- Benchmark candidates:
  - Benchmarks with efficient tradeoff of risk and return include the 1–3 year and the 1–5 year government bond indices (constructed using Merrill Lynch government bond indices for euro, yen, sterling, and U.S. dollar, weighted to SDR basket currency weights).
- Staff assessment and recommendation:
  - 1–3 year and 1–5 year government bond indices weighted to SDR basket represent a prudent balance between risk and return and have yielded higher returns than the SDR interest rate over time, with positive returns in every rolling 12-month period over the past 16 years.
  - Preference for the 1–3 year benchmark over 1–5 year benchmark based on:
    - relatively modest increase in ex ante yield from the longer duration in a relatively flat yield curve environment;
    - term premiums above two-year maturities are particularly narrow at present and have narrowed since prior analysis;
    - 1–3 year sector favored by reserve asset managers;
    - shorter duration is prudent given possibility of further increases in yields.

### V. Risk Controls
- Main risks:
  - Interest rate risk (primary) — incremental return derived largely from extending maturities.
  - Credit risk — mainly via MTIs.
  - Residual currency risk — limited by weighting to SDR basket but requiring regular rebalancing.
  - Operational risk — errors or compliance failures.
- Interest rate risk control:
  - Controlled by the duration of the benchmark indices selected for government bond and MTI portfolios.
  - 1–3 year benchmark selected as acceptable level of interest rate risk consistent with investment objective.
  - Tactical benchmark changes may be considered exceptionally to control loss risk in unusually volatile markets or when sharp yield increases appear likely; based on periodic market evaluations assessing probability of loss over a 12-month horizon, yield levels and spreads, and yield volatility.
- Currency risk control:
  - Portfolio to include securities denominated in SDR constituent currencies; currency weights adjusted to reflect SDR basket.
  - Residual currency risk arises because security values and cash flows change over time; rebalancing required.
  - Experience with PRGF-HIPC assets indicates residual currency risk can be kept low and rebalancing manageable.
- Liquidity and credit risk assessments:
  - Liquidity risk judged small given low likelihood of unanticipated calls on IA assets and inherently liquid portfolio composition.
  - Credit risk limited via BIS deposits, MTIs, securities of highly rated international financial organizations, and domestic government bonds of SDR basket countries.
  - Eligible securities limited to those rated A or higher by a major credit rating agency such as Standard and Poor’s, Moody’s, or Fitch.
- Operational risk mitigation:
  - Due diligence reviews of external managers and custodians; reconciliation of portfolio valuation by managers and custodian; stringent performance measurement and reporting; internal controls; policies complementing the Fund’s Code of Conduct.
  - Controls to mitigate actual or apparent conflicts of interest; Finance Department staff guided by policies and procedures specifying standards of professional conduct, restrictions on material non-public information, disclosure requirements for conflicts of interest, and financial disclosure requirements.

### VI. Administrative Arrangements
- Management approach:
  - Use current administrative arrangements already in place for investments.
  - External asset managers—including the World Bank and private managers—will buy and sell individual securities consistent with IA authority, guidelines, and benchmark.
  - Staff will place deposits with the BIS and structure a portfolio of MTIs.
- Manager mandates:
  - External managers given mandates consistent with IA rules, investment authority, and investment objective.
  - Mandate specifies eligible securities, acceptable market exposure, and limits on risk.
  - Each manager assigned the 1–3 year government bond index as benchmark to guide investment strategy and measure performance.
  - Managers permitted some latitude to deviate from benchmark duration to add value.
  - Reporting requirements: monthly valuations of assets and detailed quarterly reports on portfolio structure, sources of return, and investment prospects.
- Custody and valuation:
  - MTIs and BIS deposits to be held in custody by the BIS.
  - Government bonds and eligible securities managed by external managers to remain with current custodian.
  - Custodian responsibilities: safekeeping, trade settlement, income capture, asset valuation, record maintenance, performance measurement, compliance monitoring.
  - Daily portfolio valuation with full reconciliation of manager and custodian mark-to-market valuations each month.
  - Continuous compliance monitoring; custodian to sweep idle cash into short-term fund consistent with IA investment authority.

### VII. Reporting Procedures
- Semiannual reporting:
  - Semiannual reports to the Executive Board on IA operations in context of the Fund’s overall financial position, including contribution to Fund income.
  - Reports to include analysis of changes in valuation of IA assets, investment guidelines and benchmark followed by asset managers, evaluation of adequacy of risk control procedures, and assessment of market conditions affecting IA valuation.
- Ad hoc reporting:
  - Ad hoc reports to the Executive Board prepared as warranted by market or other developments.

### VIII. Proposed Decisions
- Three proposed Executive Board decisions:
  - Decision 1: Establishment of the Investment Account — may be adopted by a majority of the votes cast.
  - Decision 2: Adopt rules and regulations for administration of the IA set out in Annex I — may be adopted by a 70 percent majority of the total voting power.
  - Decision 3: Transfer of currencies from the GRA to the IA — may be adopted by a 70 percent majority of the total voting power.
- Implementation note:
  - Concurrence of members whose currencies will be used to effect the IA’s investments is required.

*Source: _041406i - 1.      This paper summarizes the relevant considerations and presents decisions for the*

### 1. The Fund hereby establishes within the General Department an Investment

### 1. The Fund hereby establishes within the General Department an Investment

### Decisions and Establishment
- Decision No. 1: The Fund establishes within the General Department an Investment Account as provided for in Article XII, Section 6(f)(i).
- Decision No. 2 (Adoption of Rules and Regulations for the Investment Account)
  - Pursuant to Article XII, Section 6(f)(vi), the Fund adopts the Rules and Regulations for administration of the Investment Account set forth in Annex I of EBS/06/57 (4/17/2006).
- Decision No. 3 (Transfer of Currencies to the Investment Account)
  - Pursuant to Article XII, Section 6(f)(ii), the Fund shall transfer from the General Resources Account to the Investment Account currencies in an amount equivalent to the amount of the Fund’s general and special reserves at April 30, 2006.
  - The transfer of currencies shall be effected in the context of the Financial Transactions Plan for the quarterly period March through May 2006 and June through August 2006.
  - The currencies transferred shall be used for immediate investment in accordance with Article XII, Section 6(f) and the Rules and Regulations adopted pursuant to Decision No. 13711-(06/40).

### Objective and Sources of the Investment Account (IA)
- Objective
  - The objective of the IA is to provide a vehicle for the investment of a part of the Fund’s assets so as to generate income that may be used to help meet the expenses of conducting the business of the Fund.
- Sources of IA Assets
  - The IA will be funded initially through the transfer of currencies from the GRA in an amount equivalent to the total amount of the Fund’s general and special reserves at the time of the decision authorizing the transfer.
  - Subject to paragraph 3, the IA may retain or invest the income from its investments, and may reinvest the proceeds of assets that mature or that it sells.

### Uses of IA Income and Termination Rules
- Uses of Income
  - The IA’s income from investment may be invested, retained in the IA, or used to meet the expenses of conducting the business of the Fund.
  - The Fund will decide on the use of the IA’s income for each financial year, including whether any portion should be transferred to the GRA for use in meeting expenses.
- Termination or Reduction
  - The IA shall be terminated in the event of liquidation of the Fund.
  - The IA may be terminated, or the amount of the currency transferred to the IA may be reduced, prior to liquidation of the Fund by a 70 percent majority of the total voting power.
  - The procedures specified in Article XII, Sections 6(f) (vii), (viii) and (ix) will apply in the event of termination or reduction.

### Investment Objective and Horizon
- Investment Objective
  - The investment objective of the IA is to achieve investment returns that exceed the SDR interest rate over time while minimizing the frequency and extent of negative returns and underperformance over a 12-month investment horizon.
  - Achieving this objective would help diversify the sources and increase the level of the Fund’s income, thereby strengthening its finances over time.

### Eligible Investments and Constraints
- Eligibility Rules (per Article XII, Section 6(f)(iii))
  - A member’s currency held in the IA may be invested only in marketable obligations of that member or in marketable obligations of international financial organizations, provided that the IA may invest only in obligations denominated in SDRs or in the currency used for investment.
  - Marketable obligations of a member include obligations of its central bank and official agencies.
  - Marketable obligations of international financial organizations include without limitation SDR-denominated deposits with the Bank for International Settlements.
- Market and Instrument Constraints
  - Investments may only be made directly in the cash markets.
  - Derivative securities—including forwards, futures, options and swaps—may not be used to establish or hedge positions in eligible investments.
  - Only long positions may be established in eligible investments. Short selling or any form of leverage is not permitted.
- Currency and Member Concurrence
  - The IA’s portfolio will be limited to eligible investments denominated in SDRs or in the currencies included in the SDR basket.
  - No investment shall be made without the concurrence of the member whose currency is used to make the investment.

### Supervision, Custody, and Risk Controls
- Supervision (Managing Director responsibilities)
  - Negotiate agreements with external investment managers and custodial agents.
  - Ensure IA activities conform with the Fund’s Articles of Agreement and these rules and regulations.
  - Establish investment benchmarks and guidelines for investment managers.
  - Place investments in eligible BIS deposits and in the BIS’ Medium-Term Instruments (MTIs).
  - Monitor structure and evaluate performance of IA assets.
  - Supervise management of IA assets, including hiring and firing external managers and assessing performance.
  - Supervise custodial arrangements; adjust portfolio allocation in response to market conditions and the Fund’s financing needs.
  - Prepare regular reports to the Executive Board on IA investment activities.
- Custody Arrangements
  - IA assets may be held in safekeeping by one or more custodian banks.
  - Custodians will hold assets in safekeeping, periodically value assets held, and hold and invest short-term residual cash balances.
- Risk Controls
  - The Managing Director will establish specific risk control procedures and put in place a mechanism to monitor their observance by asset managers.
  - Investment guidelines and benchmarks will set explicit limits for exposure to interest rate, foreign exchange, liquidity, credit and operational risks.

### Reporting and Audit
- Reporting Requirements
  - The Managing Director will provide semi-annual reports to the Executive Board on the operations and investment activities of the IA.
  - Reports will analyze IA operations in the context of the Fund’s overall financial position and income, including assessment of the appropriate size of the IA and the disposition of its assets and earnings.
  - Reports will include analysis of changes in valuation of IA assets, the investment guidelines and benchmark being followed by asset managers, discussion of applicable controls and evaluation of the adequacy of risk control procedures, and an assessment of market conditions that may affect valuation of IA assets.
  - Ad hoc reports will be prepared as warranted by market or other developments.
- Audit
  - The assets of the IA will be audited by the Fund’s external auditors and included in the Fund’s financial statements.

### Annex II — Consideration of Alternative Investment Strategies (summary of scope)
- Purpose
  - Update analysis of past risk and return characteristics of SDR-denominated bond portfolios of various maturities to assess which maturity range offers the opportunity to earn more than the SDR interest rate in most market conditions.
- Analytical Components
  - Includes a value at risk (VaR) assessment and stress tests considering past periods in which fixed income investments have performed poorly (Section B).
  - Considers implications of current level and volatility of yields for prospective returns to gauge the range of outcomes from various investment strategies (Section C).
  - Analyzes diversification and yield benefits offered by the MTIs issued by the BIS to judge appropriate portfolio weight for such instruments (Section D).
- Key strategic insight
  - Given the IA’s investment authority, the main tool to achieve the investment objective is the duration decision, with some scope to invest in credit spread instruments.

*Source: IMF decision text and Annexes as provided in the content unit.*

### conclusions of the analysis, and the investment strategy and the performance benchmark

### conclusions of the analysis, and the investment strategy and the performance benchmark

### Historical risk and return characteristics of SDR bond portfolios
- Extending maturity increases average annual return but also increases dispersion of returns due to higher sensitivity to interest rate changes.
- Historical cumulative returns (Jan. 1989–Feb. 2006) show longer duration portfolios tend to generate higher cumulative returns than shorter durations.
- Longer duration portfolios exhibit wider distributions of monthly returns and higher standard deviations.

### Past performance relative to the three-month SDR rate
- Since 1989, each bond portfolio considered outperformed the three-month SDR interest rate.
- Average annual excess return (1989–2006) by maturity:
  - Six-month portfolio: 0.10 percent
  - 7–10 year portfolio: 3.30 percent
- Intermediate portfolios (1–3 year and 1–5 year) show significantly higher Sharpe ratios than the six-month SDR rate.

### Frequency and extent of negative returns and underperformance
- Portfolios with maturity of 1–5 years or lower:
  - Have not experienced negative returns in any rolling one-year period since 1989.
- Longer maturity portfolios experienced negative returns; frequency and magnitude of losses increase with duration.
- Return shortfall versus the three-month SDR rate occurred in about 23 to 28 percent of rolling one-year horizons (Jan. 1989–Feb. 2006). Frequency similar across maturities but magnitude of underperformance increases with maturity.
- Underperformance and negative returns often occurred when yield curves were inverted and during monetary policy tightening episodes.

### Episodes of monetary policy tightening
- Tightening cycles typically detract from absolute and relative bond portfolio performance: short-term yields rise boosting short-term returns while longer maturity bonds suffer price losses.
- Portfolios up to 1–5 years generated positive returns during past tightening episodes; longer maturities experienced negative returns, notably during 1994–95.

### Value-at-risk (VaR) and stress tests (capital = SDR 1 billion)
- Annual VaR by historical performance (1989–2006) — Average Return, Standard Deviation, 95% VaR, 99% VaR (In percent / In millions of SDR):
  - 6 M: Average Return 4.54, Standard Deviation 2.05, 95% 12, 99% -2
  - 1–3 Y: Average Return 5.68, Standard Deviation 2.66, 95% 13, 99% -5
  - 1–5 Y: Average Return 6.15, Standard Deviation 3.12, 95% 10, 99% -11
  - 3–5 Y: Average Return 6.81, Standard Deviation 3.87, 95% 4, 99% -22
  - 7–10 Y: Average Return 7.86, Standard Deviation 5.70, 95% 0, 99% -54
- Interpretation: There is a 1 percent chance that in any year the 1–3 year portfolio of SDR 1 billion could lose more than SDR 5 million (0.5 percent of its value).

- Stress test based on 1- and 2-standard-deviation increases in two-year government yields (1992–2006), capital = SDR 1 billion:
  - 1–3 year portfolio:
    - Instantaneous average return: 3.71 percent
    - Average duration: 1.7
    - Expected Annualized Return with a 1 Standard Deviation shock: 1.60 percent
    - Instantaneous capital loss (SDR millions): -23
    - Capital loss as percentage: -2.3
    - Expected Annualized Return with a 2 Standard Deviation shock: -0.62 percent
    - Instantaneous capital loss (SDR millions): -45
    - Capital loss as percentage: -4.5
  - 1–5 year portfolio:
    - Instantaneous average return: 3.77 percent
    - Average duration: 2.5
    - Expected Annualized Return with a 1 Standard Deviation shock: 0.63 percent
    - Instantaneous capital loss (SDR millions): -33
    - Capital loss as percentage: -3.3
    - Expected Annualized Return with a 2 Standard Deviation shock: -2.64 percent
    - Instantaneous capital loss (SDR millions): -67
    - Capital loss as percentage: -6.7
- Note: Standard deviation calculated on daily returns since January 1, 1992.

### Impact of changes in the investment horizon
- Frequency of negative returns and underperformance declines with longer investment horizons.
- 1–3 year portfolio:
  - Negative returns in 3 percent of rolling 3-month periods (Jan. 1989–Feb. 2006).
  - No negative performance in any rolling six-month or one-year period.
- No portfolio experienced a loss in any rolling two-year period.
- Frequency of underperformance against the 3-month SDR rate over various horizons (Jan. 1989–Feb. 2006):
  - Rolling semiannual periods: bond portfolios underperformed in about 30 percent of cases.
  - Rolling quarterly periods: bond portfolios underperformed in about 37 percent of cases.
  - Over longer horizons, bond portfolios outperformed the SDR interest rate while the six-month rate lagged.

### The current interest rate environment and prospective returns (as of data through Feb/Mar 2006)
- Four noteworthy features:
  - Yields have increased since mid-2003 trough but remain below 1989–2006 averages; prospective coupon income likely lower than historical averages; current yield volatilities are below their 1989–2006 averages.
  - The SDR yield curve is relatively flat; U.S. and U.K. yield curves have been inverted—low term premium provides little income cushion against further rate increases.
  - Bank of Japan policy change increases risk of rising yields on Japanese government bonds given current very low yield levels.
  - Short-term interest rate futures imply:
    - U.S. (44 percent weight in SDR basket) approaching end of tightening cycle.
    - Gradual continuation of tightening in euro area.
    - Japanese yields expected to rise from low levels.
    - U.K. yields priced to remain little changed.
    - Synthetic SDR interest rate set to increase by about 20 basis points over the next 12 months (Table 6).

- Table 5 (Average and Current Yield and Volatility, Jan 1989–Feb 2006; Current Feb-06): current yields and volatilities expressed in number of standard deviations below 1989–2005 average for selected portfolios (examples shown):
  - 1–3 Y: Yield 4.72, Deviation 1.91, 1/Yield 3.62, Deviation 1/Volatility -0.58, Volatility 652, Deviation 2048, 1/Volatility -0.81
  - 1–5 Y: Yield 4.87, Deviation 1.85, 1/Yield 3.67, Deviation 1/Volatility -0.65, Volatility 671, Deviation 953, 1/Volatility -0.76
  - (Table preserves exact tabular values and units as in source.)

### Probability of negative returns in the current environment
- Given expected levels and volatility of yields, portfolios with maturity up to 1–5 years appear to have a low probability of negative returns.
- The 1–3 year and 1–5 year portfolios have a one percent chance, or less, of generating a negative return over the next 12 months (Table 7).
- Table 7 (selected values):
  - Yields (in percent): 1–3 year 3.71; 1–5 year 3.77; 3–5 year 3.83; 5–7 year 4.17; 7–10 year 4.15
  - Implied Volatility (in bps): 1–3 year 64; 1–5 year 67; 3–5 year 68; 5–7 year 73; 7–10 year 70
  - Probability of negative returns (in percent): 1–3 year 0.04; 1–5 year 1.07; 3–5 year 5.30; 5–7 year 12.99; 7–10 year 19.42
- The probability of loss has declined significantly in recent quarters due to higher yields and low volatility; historical peak ex ante probability for 1–3 year index was 14 percent during 2002–03.

### Diversification into Medium-Term Instruments (MTIs)
- MTI characteristics:
  - Fixed income security issued by the BIS with yield based on swap rates minus a fixed margin.
  - Two sources of return and risk: movements in government bond yields and credit spread on MTIs.
  - MTIs are a spread product; additional return aims to compensate for small credit risk.
  - MTIs perform relatively better than comparable government bonds when swap spreads narrow and vice versa.
- Past MTI performance (April 2000–January 2002), comparison to 1–3 year government bonds:
  - 1–3 Year government bonds: Annualized return 6.08 percent, Standard deviation 1.12, Risk-adjusted Return 5.42
  - MTIs: Annualized return 6.65 percent, Standard deviation 1.28, Risk-adjusted Return 5.20
  - Excess return of MTIs over 1–3 year government bonds: 0.57 percent
  - Correlation between MTIs and 1–3 year government bond benchmark: 0.89
  - Average of two-year MTI minus government bond yields: 0.08 percent
- MTI performance in recent sample periods (Sharpe ratio; Monthly Annualized Mean):
  - US dollar (Mar 1999–Dec 2005): BIS MTIs Sharpe Ratio 0.70, Monthly Return 0.39; US Treasury Sharpe Ratio 0.53, Monthly Return 0.35
  - Euro (Mar 2000–Dec 2005): BIS MTIs Sharpe Ratio 0.76, Monthly Return 0.34; Germany 0.73/0.34; France 0.73/0.34; Italy 0.87/0.36; Spain 0.80/0.35
  - Sterling (Nov 1999–Dec 2005): BIS MTIs Sharpe Ratio 0.68, Monthly Return 0.54; UK Treasury 0.49/0.50
- Yield spreads between MTIs and government bonds are broadly in line with their long-term average. MTIs appear advantageous in terms of risk-adjusted return.

### Conclusions and recommendations
- 1989–2006: All analyzed bond portfolios generated substantial cumulative excess returns over the three-month SDR rate; excess return increased with maturity while volatility also increased.
- Bond portfolios generate excess returns more consistently as investment horizon lengthens. On a one-year horizon:
  - 1–3 year portfolio outperformed the 3-month SDR rate in about three quarters of rolling 12-month periods (1989–2006).
  - The 1–3 year portfolio did not generate negative returns in any rolling 12-month period.
  - Over shorter horizons (quarterly, semiannual) frequency of underperformance increased and negative returns were experienced.
- Current environment caveats:
  - Tightening monetary conditions, relatively low interest rate volatility, and tight credit spreads mean past bond returns may not be reliable predictors of future performance.
  - Given current yield and volatility expectations, risk of loss is low on a 1–3 year portfolio.
  - Risk could be further mitigated by phasing in bond investments over months rather than implementing the investment of the IA in a bond portfolio in one shot.
- MTIs: Have provided additional return over government bonds and some diversification gains, fairly compensating for small credit risk exposure.

### Benchmark recommendation
- Both 1–3 year and 1–5 year bond benchmarks:
  - Appear consistent with the investment objective of outperforming the SDR interest rate under most market conditions while minimizing the risk of loss in any year.
- Preference for 1–3 year index given current limited term premium for maturities above two years:
  - Widely used by reserve asset managers.
  - Consistently earned positive returns in every rolling 12-month period over the past 16 years.
  - Current low probability of negative returns appears consistent with IA investment objective and risk tolerance.
- Historical performance metric:
  - During 1989–February 2006, average annual excess return over the three-month SDR interest rate for the 1–3 year benchmark was 111 basis points.
  - This index consistently generated excess return over the three-month SDR interest rate over a two-year horizon.
  - Over shorter horizons, it fell short of the three-month SDR interest rate in about one out of every four years, and in one of every three quarters.
- The 1–3 year benchmark strikes a balance between meaningful excess returns over time and limiting short-term periods of reversal.

*Source: IMF staff calculations and analyses in Annex II of the provided content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2006/_041406i.pdf_