What Is An Agency Bond?

Their issues provide higher yields than Treasurys and are seen as having an implicit zero credit risk but aren’t technically guaranteed.

How do agency bonds work?

A bond issued or guaranteed by US federal agencies or government-sponsored enterprises are known as an agency bond. Agency securities are typically bought and sold through broker-dealers.

Compared to other bonds, an agency bond often has a higher level of liquidity. They do not, however, have the same full federal guarantee and are often less liquid than treasuries. As a result, while agency bonds have greater interest rates than the Treasury, their relative lack of liquidity may make them unsuitable for investors.

Agency bonds are issued in various structures, coupon rates and maturities. 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.

Investment firms create interest-only issues by splitting mortgage-backed agency securities into different tranches or tiers. As a result, 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.

What are the types of agency bonds?

Two types of entities issue agency bonds: Government Sponsored Enterprises (GSEs) and Federal Government agencies. The main difference between a GSE and a federal agency is that a federal agency’s debt is guaranteed by a government guarantee, whereas a GSE’s obligations are not. As an illustration, a GSE is the Federal National Mortgage Association (FNMA), usually referred to as Fannie Mae. The Government National Mortgage Association (GNMA) is a federal organization known as Ginnie Mae.

Understanding GSE

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 had assisted a GSE when the Farm Credit System faced financial trouble during the 1980s. Most GSEs also have a backup for their debt in the form of lines of credit that authorize borrowing from the Treasury to pay their obligations, if necessary.

Understanding Federal Government agencies

Bonds issued by Federal Government Agency include:

• The Federal housing administration (FHPA).
• Small business administration (SBA).
• The government national mortgage association ( GNMA or Ginnie Mae).

Similar to treasuries, most bonds issued by federal government agencies are guaranteed by the federal government. Bonds issued by federal government entities may have call risk since various bonds have distinct structural characteristics. Additionally, Treasury bonds are more liquid than agency bonds issued by federal government agencies; hence, this agency bond may offer a little higher interest rate than Treasury bonds.

What is a Ginnie Mae?

Ginnie Mae is a corporation that’s part of the US Department of Housing and Urban Development (HUD). The corporation doesn’t issue bonds. Rather, it guarantees that investors who buy GNMA mortgage-backed securities (MBS) will receive timely principal and interest payments. 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. Ginnie Maes yields more than Treasurys to compensate investors for this risk, 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 known as reverse mortgages – insured by the FHA.

What are Fannie and Freddie?

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 to purchase additional loans. But when the real estate bubble, which had been created partly by relaxed lending standards, finally burst, mortgage delinquencies rose, and both GSEs were at risk of collapse.

The federal government placed them in conservatorship to reduce pressure on the financial system. As a result, among other consequences, stock in these firms lost most of its value.

What are the advantages and disadvantages of agency bonds?

Investors may receive some special advantages from investing in agency bonds. Most agency bonds, but not all, have interest that is free from federal and state taxes. Agency bonds issued by Farmer Mac, Freddie Mac, and Fannie Mae are taxable. Compared to treasuries, which are regarded as default-free, it offers larger yields.

These bonds assist in funding public policy-relevant initiatives like lending to small businesses and agriculture. Fannie Mae and Freddie Mac support the US housing market’s liquidity. They specifically buy mortgages from lenders like banks, structure them into securities, and then resell the securities to investors.

Investors should be aware of the typical risks associated with bonds in general when it comes to risks. Even though the government does not back agency debt, it is thought to have minimal default risk. However, agency bonds are subject to the risk posed by changing interest rates, just as other kinds of bonds. Credit risk is the likelihood that a bond issuer would break its promise to repay investors.

Additionally, there is a limitation on the minimum capital invested in agency bonds; for example, Ginnie Mae Agency bonds need a minimum investment of $25,000. As a result, investors with tiny investment portfolios cannot purchase these bonds. Furthermore, according to local or state regulations, Completely Taxable-Agency Bond Issuers like GSE Entities Freddie Mac and Fannie Mae are fully taxable. However, any capital gains or losses from the sale of agency bonds are subject to taxation under the law.

What Is An Agency Bond? by Inna Rosputnia

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