Agency Bond

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An agency bond is a security that has been issued by a federal agency other than the U.S. Treasury or a government-sponsored company. Unlike U.S. Government and municipal bonds, some are not entirely guaranteed. Agency debt is another name for a bond issued by an agency.

A government-sponsored enterprise (GSE) is a for-profit business that has a public mission, such as supporting international trade or offering student, agricultural, or house loans. Governmental oversight and regulation are some of the rights and responsibilities that GSEs are given under the terms of their government charters. Contrary to federal agencies, GSEs are not directly backed by the U.S. government's full faith and credit. They instead benefit from a lower borrowing cost than other private firms because they are implicitly guaranteed by the government that they will not fail.

A federal agency is a division or entity that works for the public interest and is part of the executive branch of the U.S. government. To fund their operations or initiatives, such as housing, education, or infrastructure, federal agencies issue bonds. Federal agency bonds are expressly guaranteed by the full faith and credit of the United States government, which means that in the event of default, the government will pay the principal and interest due on the bonds.

How do agency bonds differ from Treasury bonds?

Treasury bonds are debt instruments that the U.S. Department of Treasury issues to pay for the federal government's budget shortfalls and debt obligations. The maturities of Treasury bonds range from 10 to 30 years, and they offer set coupons that are paid every two years. Since there is no credit risk or default risk associated with Government bonds, they are among the safest and most liquid investments available.

In terms of their structure and characteristics, agency bonds and Treasury bonds are comparable. For example, both have fixed or floating coupon rates, semi-annual interest payments, and a range of maturities. However, agency bonds have some differences from Treasury bonds that affect their risk and return profiles:

• Due to their higher credit risk and weaker liquidity than Treasury bonds, agency bonds have slightly higher interest rates than Treasury bonds of comparable maturity and grade. The spread, which changes based on the kind and issuer of the agency bond as well as market conditions, is the difference in yield between agency bonds and Treasury bonds.
• Agency bonds could be callable, giving the issuer the choice to redeem them before the date of scheduled maturity if interest rates fall or if the issuer wants to refinance its debt at a lower rate. To make up for the increased risk of reinvestment that comes with callable agency bonds, callable agency bonds often have higher coupon rates than non-callable agency bonds.
• Depending on whether they are issued by GSEs or government agencies, agency bonds may or may not have different tax implications than Treasury bonds. While federal agency bonds are typically exempt from both federal and state taxes, GSE agency bonds are subject to federal income tax but not state or local taxes (except for some specific issuers). Before purchasing agency bonds, investors should speak with their tax professionals.

What types of agency bonds are available?

Agency bonds can be divided into two categories: mortgage-backed securities (MBS) and non-mortgage-backed securities (non-MBS). MBS are securities that represent collections of loans that were originated by lenders and packaged by GSEs or government organizations. Securities known as non-MBS reflect direct loans or guarantees issued to borrowers in various industries by GSEs or federal agencies.

Some of the most common issuers of agency bonds are:

• The Federal National Mortgage Association (Fannie Mae) issues non-MBS and securitizes conventional mortgages (those not covered by government insurance) into MBS for housing-related uses.
• The Federal Home Loan Mortgage Corporation (Freddie Mac) issues non-MBS and securitizes conventional mortgages into MBS for housing-related uses.
• The Government National Mortgage Association (Ginnie Mae), which backs MBS with mortgages covered by the Federal Housing Administration (FHA), Department of Veterans Affairs (VA), Department of Agriculture (USDA), or other federal programs.
• The Federal Home Loan Banks (FHLBs) finance housing and community development through non-MBS for member banks and thrifts.
• Agricultural and rural financing through non-MBS is funded by the Federal Farm Credit Banks (FFCBs), which are member cooperatives and institutions.
• The Federal Agricultural Mortgage Corporation (Farmer Mac) issues non-MBS for agricultural and rural uses and securitizes agricultural loans into MBS.
• Student Loan Marketing Association (Sallie Mae) offers non-MBS and securitizes student loans into MBS for educational purposes.
• The Private Export Financing Corporation (PEFCO), backed by U.S. government assets and insured by the Export-Import Bank of the United States, offers financing to American exporters and international purchasers through non-MBS (Ex-Im Bank).

What are the benefits and risks of investing in agency bonds?

Investing in agency bonds can offer several benefits to investors, such as:

• Due to agency bonds' higher credit risk and lower liquidity than Treasury bonds of comparable terms and grade, they offer a higher yield.
• Reduced credit risk compared to corporate bonds of comparable duration and quality since agency bonds are implicitly or explicitly guaranteed by the U.S. government, lowering the danger of default.
• Risk diversification in the portfolio is necessary since agency bonds carry distinct kinds of risk and return than other fixed-income instruments, including interest rate risk, prepayment risk, and reinvestment risk.
• Diversity is possible because agency bonds come with a range of structures and characteristics, including callable and non-callable options, fixed or floating coupon rates, and a range of maturities, that can be tailored to the tastes and goals of individual investors.

However, investing in agency bonds also involves some risks, such as:

• Interest rate risk, which is the risk that the value of a bond will decline when interest rates rise, as bond prices and interest rates move inversely. Interest rate risk is higher for longer-term bonds than shorter-term ones, as longer-term bonds have more future cash flows that are discounted at higher rates when interest rates rise.
• Prepayment risk, which is the chance that the bond's issuer may pay back the bond's principal before the bond's due date, typically occurs when interest rates drop. Callable bonds have a higher prepayment risk than non-callable ones since the issuer has the opportunity to redeem them at a set price prior to maturity. While MBS are backed by mortgages that can be refinanced or paid off by borrowers when interest rates decrease, prepayment risk is, therefore, higher for MBS than for non-MBS.
• Reinvestment risk refers to the possibility that an investor won't be able to reinvest the principal and interest payments from a bond at a rate of return equal to or greater than the original. Shorter-term bonds have a larger reinvestment risk than longer-term bonds because they generate cash flows more frequently, which must be reinvested at current market rates. Compared to non-callable bonds and non-MBS, reinvestment risk is higher for callable bonds and MBS since they run the danger of returning the investor's principal in the event of a prepayment before maturity.