Bonds help add diversity to your portfolio and control risk. But they can be complicated. We can help you understand the basics about agency bonds and make them work for you.
What are agency bonds?
A number of U.S. government agencies and government sponsored enterprises (GSE) issue debt securities. The key difference between a GSE and a federal agency is that a GSE’s obligations are not guaranteed by the government, whereas a federal agency’s debt is backed up by a government guarantee. Bonds issued by a GSE are backed only by that GSE's ability to pay.
Agency bonds are typically issued through broker-dealers. The bonds are offered in maturity terms ranging from less than a year to 30-year. Some agency bonds may be callable and subject to call risk. Agency bonds are less liquid than treasury bonds and usually pay a slightly higher interest rate as compensation. Minimum-purchase requirements vary greatly, ranging from $1,000 to $25,000.
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Interest earned on GSE debt is taxable, while interest on federal agency debt is tax-exempt. It is an important detail as taxability may impact price and return.
Agency vs. GSE
Government agencies include:
- Government National Mortgage Association (GNMA or Ginnie Mae)
- Small Business Administration
- Federal Housing Administration
These bonds are backed by the full faith and credit of the U.S. government to pay interest and pay back principal at maturity. Although the Tennessee Valley Authority is a government agency, (TVA) bonds are not backed by a government full faith and credit guarantee but rather by the power revenue generated by the Authority.
GSEs include:
- Farm Credit Banks
- Farm Credit System Financial Assistance Corporation
- Federal Home Loan Banks
- Federal National Mortgage Association (FNMA or Fannie Mae)
- Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
- Federal Agricultural Mortgage Corporation (Farmer Mac)
- Student Loan Marketing Association (Sallie Mae)
GSEs are not backed by the full faith and credit of the U.S. government. These bonds are subject to both credit risk and default risk and the yield on these bonds is typically slightly higher than on U.S. Treasury bonds.
Note: Freddie Mac and Fannie Mae were both placed into conservatorship by the Federal Housing Finance Agency (FHFA), on September 6, 2008. This essentially confirmed the market's longstanding assumption that the GSEs' debt securities would be backed by the U.S. Government in case of crisis.
Ginnie, Fannie and Freddie
Among the most popular of agency securities are those backed by the Government National Mortgage Association, or Ginnie Mae, which helps create a secondary market for home mortgages.
Ginnie Mae securities are called pass-through certificates and come in minimum denominations of $25,000. But for as little as $1,000, you can buy into a Ginnie Mae mutual fund or unit trust.
Freddie Mac participation certificates (issued by the Federal Home Loan Mortgage Corp.) and Fannie Mae securities (issued by the Federal National Mortgage Association) come in denominations starting at $1,000.
The risk and rewards of mortgage-backed securities
Mortgage-backed securities can be a solid addition to an investment portfolio, but many investors don't understand the risks. As with bonds, their market value declines as interest rates rise. But Ginnies, Fannies, and Freddies carry another risk: as mortgage rates go down and homeowners refinance, their mortgages get paid off and drop out of the pool.
Investors get the principal back, but the lucrative return goes up in smoke. This has the perverse effect of driving the price of Ginnie Maes and similar issues down at the very time that the price of bonds is going up.
Meanwhile, because you're at the mercy of thousands of homeowners making independent decisions about when to refinance, the principal comes back to you in unpredictable chunks. Your cash flow is erratic and so is your yield. To compensate for this uncertainty, mortgage pools have generally had to pay a percentage point or two more than Treasury bonds, which are much more predictable.
Bottom line
U.S. agency bonds are a highly rated bond investment that give you the opportunity to gain a higher return than Treasury bonds, while sacrificing very little in terms of risk or liquidity. GSE's also offer a higher return, but with slightly more risk than an agency bond.
Agency bonds and GSEs are considered to have a high credit quality due to the implicit or explicit guarantee provided by the issuing agency or the U.S. government. Those that are not directly backed by the full faith and credit of the U.S. government, are still perceived as having lower credit risk than corporate bonds.
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