Bond Basics: U.S. Agency Bonds

These investments are close enough to government bonds in terms of safety, but make sure you're aware of the risks.

Bonds help add diversity to your portfolio and control risk. But they can be complicated. We can help you understand the basics and make bonds work for you.

A number of U.S. government agencies and federally sponsored enterprises issue debt securities. They usually do not carry the full faith and credit of the government, but this difference is really quibbling because it's doubtful that the government would allow one of its agencies to default on an obligation.

Nevertheless, the difference is usually reflected in the relative yields of agency versus Treasury debt instruments. Agency issues, being the "inferior" risk, pay a bit more, despite the additional fact that some agency securities — but not all — are exempt from state and local income taxes, just like Treasury issues.

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A description of the various securities available would amount to a description of the issuing agencies' functions. Some issue short- as well as long-term debt instruments. Most float mainly intermediate-term issues. Minimum-purchase requirements vary greatly, ranging from $1,000 to $25,000. Purchases must usually be made through brokers, who can supply a listing of the securities available.

Ginnie, Fannie, and Freddie: Mortgage-Backed Securities

Among the most popular of agency securities are those backed by the Government National Mortgage Association, or Ginnie Mae (opens in new tab), 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 (opens in new tab) participation certificates (issued by the Federal Home Loan Mortgage Corp.) and Fannie Mae (opens in new tab) securities (issued by the Federal National Mortgage Association) come in denominations starting at $1,000.

Mortgage-backed securities can be a solid addition to an investment portfolio, but many investors don't seem to 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.