Understanding Agency Bonds

Introduction

Agency bonds, contrary to their name, do not indicate securities issued by any federal government agency. Instead, they’re securities issued by entities specially set up by the government but not funded directly by the government. Therefore, people often consider them less secure than Treasury bonds but safer than corporate bonds.

Who Issues Agency Bonds?

Common issuers of agency bonds include Government-Sponsored Enterprises (GSEs) and Federal Government Agencies. Congress established GSEs, such as Fannie Mae and Freddie Mac, but they are now privatized businesses. Despite the fact that the federal government does not explicitly guarantee their bonds, they benefit from an increase in credit rating due to their affiliation with the government. The Federal Farm Credit Banks and the Federal Home Loan Banks are examples of Federal Government Agencies that issue agency bonds. The United States Government fully guarantees their bonds.

How Does an Agency Bond Work?

When investors purchase agency bonds, they’re essentially lending money to these entities. In return, the issuing agency promises to repay the principal at a specified maturity date and make periodic interest payments, known as coupon payments. These interest rates can be fixed or variable.

Types of Agency Bonds

The three main types of agency bonds are Callable Agency Bonds, Agency Discount Notes, and Mortgage-Backed Securities.

1. Callable Agency Bond

The issuer retains the right to call back or redeem the bond before the maturity date. This is typically done when interest rates drop, enabling the issuer to pay off old debt and acquire new debt with a lower interest rate.

2. Agency Discount Note

These are short-term securities (ranging from a few days to one year) that pay no interest and are sold at a discount to par value. The difference between the purchase price and the face value is the investor’s yield.

3. Mortgage-Backed Securities (MBS)

MBS are unique types of agency bonds primarily issued by GSEs. They pool together mortgages and sell them as securities to investors. The interest and principal payments made by borrowers are passed onto MBS investors, minus a management fee.

Risk and Return Associated with Agency Bonds

Due to the fact that agency bonds do not have the full faith and credit of the U.S. government backing them, they have a slightly higher yield than Treasury bonds. However, the risk is still considerably lower than corporate bonds, making agency bonds a middle ground for investors seeking a balance between risk and return.

As for credit risk, it is relatively low since these bonds are issued by agencies with a government connection. However, they do face interest rate risk, like all bonds. If interest rates rise, the price of the bond falls, causing a capital loss if you sell before maturity.

How are Agency Bonds Taxed?

Interest income earned on most agency bonds is subject to federal tax, but it’s typically free from state and local taxes. However, bonds issued by certain agencies, such as the Tennessee Valley Authority, are subject to all types of taxes.

How do I Buy Agency Bonds?

Agency bonds can be purchased from a broker-dealer or an investment adviser. Prices and yields will vary, so it’s wise to do comparison shopping. Note that many agency bonds are callable, so it’s crucial to understand the potential call risk before buying.

End Note

Agency bonds are a type of investment that offers a balance between risk and return. They are relatively secure as they are linked to government agencies or enterprises while providing a higher yield than government securities. However, they do possess risks, including interest rate and call risk, that potential investors should be aware of. Always do your due diligence and consider your risk tolerance and investment horizon before venturing into agency bonds. If possible, consult a financial advisor to guide you based on your financial goals and needs.