Agency bond is an umbrella term that covers different types of securities. The Rural Electrification Program, for example, issues bonds through the Federal Financing Bank, a unit of the US Treasury that helps government agencies raise capital. Bonds issued by most federal agencies carry the same risk-free credit status as Treasury issues.
Another category, Ginnie Mae securities, is also free of credit risk, though these government-guaranteed issues are actually offered by private companies.
Positioned somewhere between the federal government and publicly held companies are entities called government-sponsored enterprises (GSEs). GSEs are run as corporations under government charters specifying their specific mission. Their issues provide higher yields than Treasurys, are seen as having an implicit zero credit risk, but aren’t technically guaranteed.
Types of agency issues
Discount notes mature in less than a year. Like Treasury bills, discount notes don’t pay a coupon. Instead, as the name implies, you buy them at a discount and cash them in at par at maturity. The interest earned is the difference between the original price and par. Zero-coupon bonds or zeros pay no coupon and are created by securities firms out of agency bonds. Interest accrues unpaid at a fixed compounded rate. At maturity, you get one payout consisting of both principal and interest.
Interest-only issues are created by investment firms by splitting up mortgage-backed agency securities into different tranches, or tiers. They pay investors only the interest portion of mortgage payments. Principal-only issues, like interest-only issues, are created by investment firms out of mortgage-backed agency securities. They’re sold at a discount and pay investors principal payments but no interest.
Ginnie Mae, government agent
Ginnie Mae is a corporation that’s part of the US Department of Housing and Urban Development (HUD). The corporation doesn’t actually issue bonds. Rather, it guarantees that investors who buy GNMA mortgage-backed securities (MBS) will receive timely payment of principal and interest. These MBS are created from federally insured loans made by the Federal Housing Administration (FHA) or federally guaranteed loans from the Department of Veterans Affairs (VA) and issued by private firms.
Even though the bonds Ginnie Mae guarantees have zero credit risk, they’re still vulnerable to interest rate risk, so their market prices change as interest rates change. They’re also subject to prepayment risk — the risk that homeowners will pay off their mortgages ahead of schedule, interrupting an anticipated income stream. To compensate investors for this risk, Ginnie Maes yield more than Treasurys, though generally less than GSE securities. In addition to MBS backed by mortgage loans on single- and multifamily properties, Ginnie Mae issues securities backed by home equity conversion mortgages (HECM) — better knows as reverse mortgages — insured by the FHA.
GSEs are organized and managed as corporations. Some, like Farmer Mac, are publicly owned companies listed on the New York Stock Exchange. Others, including the Federal Home Loan Bank, are not publicly traded. But all GSEs enjoy a special relationship with the government, which defines their roles, oversees their activities, and provides an implicit guarantee for their debt. The implicit guarantee of GSEs is not as solid as the “full faith and credit” guarantee of Treasurys.
But investors — and the financial markets — generally assume that a GSE default would be so disastrous to the economy that the government would use Treasury funds to bail it out. That’s not a rash assumption. The government has come to the assistance of a GSE in the past, when the Farm Credit System faced financial trouble during the 1980s. Most GSEs also have backup for their debt in the form of lines of credit that authorize borrowing from the Treasury to pay their obligations, if need be.
What are Fannie and Freddie?
Perhaps the most complicated GSE relationship is the one the federal government has with Fannie Mae and Freddie Mac, the two damaged giants of the residential mortgage industry. Once highly regarded and widely owned corporations, their future — and the future of government involvement in mortgage lending — remains unresolved.
These separate but similar organizations were created to make homeownership more available to borrowers who met clearly defined criteria for down payments and debt ratios. They buy conforming mortgage loans from lenders, providing cash to make more loans. Then they bundle the loans into pass-through securities and sell the securities to raise money for the purchase of additional loans. But when the real estate bubble, which had been created in part by relaxed lending standards, finally burst and mortgage delinquencies rose, both GSEs were at risk of collapse. The federal government placed them in conservatorship to reduce pressure on the financial system. Among other consequences, stock in these firms lost most of its value.
What Is An Agency Bond? by Inna Rosputnia
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