Buy U.S. Agency Bonds
The fur is flying in Washington and in cyberspace about the creditworthiness of Fannie Mae and Freddie Mac. At issue is whether bonds issued by the huge but troubled mortgage companies are as safe as U.S. Treasury debt. If the answer is yes, you can earn more than you can with Treasuries with virtually no additional risk.
The background: In September 2008, the government took control of Fannie and Freddie and put them into conservatorship. The move resolved the uncertainty over whether the Treasury would backstop the two government-sponsored enterprises in the event of insolvency. Fannie and Freddie survive and continue to sell bonds, buy mortgages and package home loans into securities. Stockholders got annihilated. In 2007, the combined stock-market value of Fannie and Freddie exceeded $100 billion. Today, the pair are worth $2.4 billion. Their bonds also took a hit but have since recovered.
Agency potpourri. Fannie and Freddie are not the only sellers of non-Treasury government-backed bonds. This group also includes the Tennessee Valley Authority, Federal Farm Credit Banks and Federal Home Loan Banks, and the Government National Mortgage Association, also known as Ginnie Mae (Ginnie doesn't actually issue bonds; it guarantees high-quality mortgage securities assembled by financial institutions). When it comes to safety -- that is, the timely payment of interest and principal -- bond professionals regard all of these agency securities as equivalent to Treasuries.
Of course, no one is forcing you to invest in agency bonds. The Treasury, you've probably heard, has plenty to go around. That's one reason that, even though yields have climbed 0.7 percentage point since late December, it's tough to recommend Treasury bonds. The coming supply needed to fund massive deficits is breathtaking. The reason for investing in agency bonds is simply that they yield more than Treasuries. Historically, the spread has been 0.2 percentage point more than Treasuries of the same maturity. One reason for the gap is structural. The market for agency bonds isn't as large as the Treasury market, and new agency bonds aren't issued as frequently as Treasuries are. As a result, agencies have to pay more to sell their debt.
The second reason for the spread, says Lisa More, director of fixed income for Wilmington Trust, a Delaware bank and money manager, has to do with perception. Some investors reason that a wholly owned subsidiary of the U.S. government, such as the TVA, isn't the same as the government itself. There's a sense, says More, "that you might not have as much protection" should an agency run a big loss, as Fannie and Freddie have been doing. This, she adds, is more about fear of "headline risk" than actual risk. Without flinching, More puts up to one-third of her clients' bond portfolios in agency securities.
Your decision to invest in agency bonds should not rest on perceptions and semantics. It should be based on value in the marketplace. If you can get a better yield owning an agency bond instead of an equivalent Treasury, then buy it. Agency securities won't make you rich. And if Treasuries stumble because of rising interest rates (bond prices move inversely with rates), agencies won't be spared. But the tangible reward of going the agency route will add up. Here are examples of the agency yield advantage in mid April:
Two-year notes. Treasury, 1.1% yield to maturity. Federal Home Loan Banks, 1.9%. Fannie Mae, 1.9%.
Five-year zero-coupon bonds. Treasury, 2.7%. Fannie Mae, 3.1%.
Ten-year bonds. Treasury, 3.9%. TVA Electronotes (callable in 2012), 4.1%. Federal Farm Credit, 4.3%.
Because of the chance that interest rates will go higher should the economy break loose, I wouldn't recommend going out longer than ten years.