U.S. Agency Bonds Bond Basics
U.S. Agency Bonds Bond Basics
The Fascinating World of Agency Bonds: A Comprehensive Guide
Investing in bonds is a fantastic way to diversify your portfolio and manage risk. But let’s face it, bonds can be a bit complicated. That’s where we come in. We are here to help you understand the basics of agency bonds and how you can make them work for you.
What Are Agency Bonds?
In the United States, several government agencies and government-sponsored enterprises (GSEs) 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, while a federal agency’s debt is backed by a government guarantee.
Agency bonds are typically issued through broker-dealers and have maturity terms ranging from less than a year to 30 years. Some agency bonds may be callable and subject to call risk. Compared to treasury bonds, agency bonds are less liquid but usually offer slightly higher interest rates as compensation. Minimum-purchase requirements vary greatly, ranging from $1,000 to $25,000.
It’s important to note that interest earned on GSE debt is taxable, while interest on federal agency debt is tax-exempt. This taxability factor can impact the price and return of the bonds.
Agency vs. GSE
Government agencies that issue bonds backed by the full faith and credit of the U.S. government include:
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- Government National Mortgage Association (GNMA or Ginnie Mae)
- Small Business Administration
- Federal Housing Administration
These bonds are considered to be extremely safe investments. However, the Tennessee Valley Authority (TVA) bonds, although backed by a government agency, are not guaranteed by the full faith and credit of the U.S. government. Instead, they are backed by the power revenue generated by the Authority.
On the other hand, GSEs are not backed by the full faith and credit of the U.S. government. They carry credit risk and default risk, which means that there is a chance of non-payment. Some well-known 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)
It is worth mentioning that the Federal Housing Finance Agency (FHFA) placed both Freddie Mac and Fannie Mae into conservatorship on September 6, 2008, confirming the market’s assumption that the government would back the GSEs’ debt securities in times of crisis.
Ginnie, Fannie, and Freddie
Among the most popular agency securities are those backed by the Government National Mortgage Association (Ginnie Mae). Ginnie Mae helps create a secondary market for home mortgages. Ginnie Mae securities, known as pass-through certificates, have minimum denominations of $25,000. However, for as little as $1,000, you can invest in 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 fail to grasp the risks involved. Similar to bonds, the market value of mortgage-backed securities declines as interest rates rise. However, Ginnie Maes, Fannies, and Freddies come with an additional risk: prepayment risk. As mortgage rates decrease, homeowners refinance their mortgages, causing them to drop out of the pool.
While investors get their principal back, the expected return diminishes. Oddly enough, this drives down the price of Ginnie Maes and similar issues just when the price of bonds is rising.
Furthermore, because you are at the mercy of thousands of homeowners making independent decisions about refinancing, the principal comes back to you in unpredictable chunks. This can result in erratic cash flow and yield. To compensate for this uncertainty, mortgage pools generally have to offer slightly higher interest rates compared to more predictable Treasury bonds.
The Bottom Line
U.S. agency bonds are highly rated investments that offer the opportunity to achieve higher returns than Treasury bonds while sacrificing very little in terms of risk or liquidity. GSEs also provide higher returns, but with slightly more risk than agency bonds.
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. Even those not directly backed by the full faith and credit of the U.S. government are still perceived to have lower credit risk than corporate bonds.
So, whether you are a savvy investor or just starting out, agency bonds can be a valuable addition to your investment strategy. They offer diversity, control risk, and the potential for higher returns. Don’t be intimidated by their complexity; we’ve got your back. Take the plunge into the fascinating world of agency bonds!
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