Agency bonds are issued by either agencies of the U.S. government or government-sponsored enterprises (GSEs), which are federally chartered corporations but publicly owned by stockholders.
Agency and GSE bonds are one way to create a more diversified portfolio without assuming excessive credit or inflation risk. The varying objectives of the individual government-sponsored entities, and their continuing demand for capital, usually enable customers to find a specific product to match their individual needs.
Bonds issued by GSEs
These include bonds such as the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Banks and the Federal Farm Credit Banks. Because GSEs are owned by shareholders and not part of the federal government, these bonds are not backed by the government’s “full faith and credit” guarantee and are therefore subject to credit and default risk.
Bonds issued or guaranteed by U.S. federal government agencies
Federal agencies, such as the Government National Mortgage Association (Ginnie Mae), are part of the federal government; as such, they are backed by the “full faith and credit” of the U.S. government. Ginnie Mae, however, does not issue bonds directly; it insures or guarantees mortgage-backed securities originated by other lenders. Not all agencies have government backing; one example is the Tennessee Valley Authority (TVA). TVA bonds are not backed by the U.S. government. Instead, they’re backed by the revenues generated by the agencies’ projects.
New issue agency and GSE bonds
New issue bonds are typically sold through broker-dealers, who purchase them in large blocks, then make the securities available to other institutions and to individuals. Although most may have a minimum order quantity of one bond, others have minimum purchase sizes of 5 or 10 bonds, with minimum investment amounts of $5,000 or $10,000, respectively. Please check the Bond Details page of the issue you are considering when placing orders.
Yields above Treasuries
GSE and agency bonds generally offer yields slightly higher than U.S. Treasuries of the same maturity. The extra yield is a reflection of the fact that their credit risk does not have the unconditional backing of the U.S. government, though they are considered to be high credit quality.
Agency and GSE bonds have historically been considered to be of high credit quality. However, investors should consider the balance sheets which may be highly leveraged and concentrated in real estate loans.
Variety of structures
Agencies and GSEs may offer zero-coupon notes, which are short-term obligations issued at a discount, with maturities ranging from overnight to 360 days, as well as bonds with maturities of greater than one year. While many bonds issued by agencies and GSEs are non-callable, they also issue callable bonds with "step-up" coupon rates, in which the coupon increases at regular intervals while the bond is outstanding.
The tax treatment of agency and GSE bonds depends on the bond issuer and your own tax situation; it always makes sense to consult a professional.
Interest income from some agency bonds, such as those issued by Federal Farm Credit Banks Funding Corporation, Federal Home Loan Banks, and Tennessee Valley Authority (TVA), is exempt from state and local tax. The interest income from bonds backed by Fannie Mae and Freddie Mac, however, is not exempt from state and local tax. If you sell a bond before maturity for a profit, that profit will be subject to federal and state capital gains tax.
A relatively active secondary market exists for many agency and GSE bonds. The size of the market and features of each security affect liquidity. Note that many agency and GSE bonds are structured to meet the needs of a particular class of investor, often with the expectation that the bonds will be held until maturity.
Some agency or GSE bonds have call features, which means they can be redeemed or paid off at the issuer’s discretion prior to maturity. Typically an issuer will call a bond when interest rates fall, potentially leaving investors with a capital loss or loss in income and less favorable reinvestment options. For investors concerned about call risk, non-callable agency and GSE bonds are available in the marketplace.
Interest rate risk
Like all bonds, GSEs and agency bonds are susceptible to fluctuations in interest rates. If interest rates rise, bond prices will generally decline despite the lack of change in both the coupon and maturity. The degree of price volatility due to changes in interest rates is usually more pronounced for longer-term securities.
Credit and default risk
While GSE bonds have relatively low credit risk, there is some risk that the issuing GSE will default. Agency and GSE issued bonds are not an obligation of the U.S. government, with credit and default risk based on the individual issuer.
While the yields on agency and GSE bonds are usually higher than those offered by Treasuries, there is a risk that the income generated may be lower than the rate of inflation. Inflation may diminish the purchasing power of a bond’s interest and principal.