Agency Bonds
Issued or backed by a federal agency or a government-sponsored business.
What are Agency Bonds?
Agency bonds are issued or backed by a federal agency or a government-sponsored business (GSE). Often known as "agencies," can aid in diversification and offer tax benefits.
It can be easier to decide whether to incorporate agencies in your portfolio if you know how they operate and their benefits and drawbacks.
Agency debt is another name for agencies.
A federal agency may only issue agency bonds with the full faith and credit of the United States of America.
The government is committed to ensuring that investors receive interest payments from the bonds and their original investment's principal back. Agency bonds are therefore seen as having little credit risk.
They do not have the same full federal guarantee and are often less liquid than treasuries. As a result, although agencies have greater interest rates than treasury bonds, some investors may find them unsuitable due to their relative lack of liquidity.
How Agency Bonds Work
Broker-dealers frequently issue agency bonds. By underwriting agency debt, certain renowned broker-dealers, including J.P. Morgan, Nomura, and BNY Mellon, take part in the market. They purchase agency debt in bulk at a discount and then sell it to investors on the secondary market for a profit.
Most of these have a semi-annual fixed coupon and are offered for sale in a range of increments, with the first increment often requiring a $10,000 investment and subsequent ones $5,000. However, GNMA securities are only available in $25k increments.
While some of these have floating interest rates, others have fixed rates. The interest rates on these floating rates are periodically changed to reflect changes in a benchmark rate, such as LIBOR.
These are subject to interest rate concerns, like other bonds. After purchasing bonds, a bond investor can find that interest rates have increased.
The bond's actual purchasing power is lower than it was. Waiting for a higher interest rate would have allowed the investor to earn more money. Naturally, the price of long-term bonds is more vulnerable to this risk.
The way agencies operate is as follows: A bond buyer anticipates receiving interest payments and a return of principal at maturity.
The entity issuing it, along with the minimal investment needed and their tax classification, set them apart from other forms of bonds. They are once again issued by GSEs or federal government entities.
The issuer decides interest rates on it when the bond is created.
Characteristics of Agency Bonds
The mortgage-backed securities market is heavily vulnerable to Fannie Mae and Freddie Mac. These organizations suffered significant losses when mortgage defaults increased during the subprime mortgage crisis.
Its subsequent inability to secure funding and fulfill its obligation nearly caused them to collapse, severely impacting the US housing and mortgage lending industries. The US government coerced them into a bailout to avert the worst-case scenario.
Ginnie Mae serves a similar purpose, but because it is a federal government entity, it is fully guaranteed by the federal government, unlike the other two corporations. They are independent and are managing for-profit businesses as GSE.
They benefit from an implicit federal guarantee that tempts lenders to give more lenient terms. The subprime mortgage crisis of 2007 put this to the test.
Fannie Mae and Freddie Mac received large financial injections from the federal government, and both companies were placed into conservatorship in September 2008.
These organizations are under the conservatorship of the US government and FHFA, which oversees the secondary mortgage markets in the US.
Risks of Agency Bonds
These bonds are subject to many kinds of risks, like other bonds. Like, after purchasing bonds, a bond investor can find that interest rates have increased, its actual purchasing power is lower than it was, waiting for a higher interest rate to take effect that causes the investor to earn more, etc.
Let us discuss the risk factors while investing in these bonds.
1. Call risk
Some agency or GSE bonds include call provisions, which allow the issuer to redeem or pay them off before maturity.
When interest rates drop, an issuer will frequently call a bond, potentially leaving investors with a loss of capital or income and less favorable reinvestment possibilities.
Non-callable agencies and GSE bonds are available for investors worried about call risk.
GSEs and agency bonds are subject to interest rate changes, just like any other bonds. Despite no difference in the coupon or maturity, bond prices will often decrease when interest rates rise.
Longer-term assets typically experience greater price volatility due to interest rate increases.
3. Credit and default risk
Despite the comparatively minimal credit risk associated with GSE bonds, there is a slight chance that the issuing GSE will go out of business.
Bonds issued by agencies and GSEs are not obligations of the United States government; instead, credit and default risk are determined by the particular issuer.
While agency and GSE bond yields are often more significant than those of treasury bonds, there is a chance that the income derived will be below the rate of inflation. The purchasing power of a bond's interest and the principal may be lowered by inflation.
Types of Agency Bonds
There are mainly three types based on the authority it is being issued by, namely - Issued by a federal government agency, Issued by a government-sponsored organization, new issue agency, and GSE bonds.
Let us discuss each of them in a broader view.
1. Issued by a federal government agency
These include the Government National Mortgage Association (GNMA), the Small Business Administration (SBA), and the Federal Housing Administration (FHPA) (GNMA or Ginnie Mae).
Like treasury bonds, federal government agencies' bond issuances are typically guaranteed by the federal government. Unfortunately, the Tennessee Valley Authority is one organization that lacks federal support (TVA).
The U.S. government does not provide backing for TVA bonds. Instead, they are funded by the money made from the initiatives the agencies work on.
2. Issued by a government-sponsored organization
It includes the Funding Corporation, Federal Home Loan Bank, Federal Farm Credit Banks, Federal National Mortgage Association (Fannie Mae), and Federal Home Loan Mortgage (Freddie Mac).
GSEs are quasi-governmental institutions established to increase credit availability and lower borrowing costs for specific economic sectors.
Over time, this will lower investors' overall risk of capital loss. The federal government oversees these organizations but does not have direct management.
These are independently owned, and their purpose is to make money by supplying capital markets with liquidity.
They do this by purchasing loans and holding them in their portfolios, investing in capital stock and debt securities that guarantee MBS, and earning fees for guarantee and other services.
3. New Issue Agency and GSE bonds
Bonds for new issues are often bought in bulk by broker-dealers, who subsequently offer the securities to other institutions and private buyers.
While the majority may only allow for orders of one bond, others may only permit orders of five or ten bonds, with minimum investments of $5,000 or $10,000, respectively.
When placing an order, please review the bond details page of the issue you are about to order.
Advantages of Agency Bonds
Every investment comes with advantages and disadvantages. The same goes for Agency Bonds.
Advantages
1. Less credit risk
Because the US government agency bonds are issued and guaranteed by a government agency and contain an implicit and explicit government guarantee, even though they do not carry the full faith and credit guarantee, they are thought to carry lesser credit risks.
Additionally, they ensure that the principal and interest payments on the securities they sell will be made. These organizations collectively guarantee half of the US mortgages with outstanding balances of USD 12 trillion.
2. Higher Return
Due to the increased credit risks, they offer more favorable borrowing rates than any other bond.
- Good source of funding: These bonds contribute to financing public policy-relevant initiatives like lending to homebuyers, small businesses, and the agricultural sector. They support economic sectors that might otherwise find it challenging to acquire funding sources within their means.
- Infuse Liquidity: Freddie Mac and Fannie Mae help the US housing market to have more liquidity. More precisely, they buy mortgages from lenders like banks, repackage them as securities, and then sell them to investors.
- Exemption from local taxes: The interest on the majority of agency bond offerings is free from local and state taxes, but it is still crucial for investors to comprehend the tax implications before making a purchase.
Disadvantages of Agency Bonds
Disadvantages are:
1. Minimum capital requirement
Ginnie Mae Agency bonds demand a minimum investment of $25,000, so an investor with a small investment portfolio cannot purchase these bonds. Agency bonds have a minimum capital amount that can be invested.
2. Complexity
Some agency bond issues include characteristics that make them more structured and complex, further decreasing their liquidity and making them unsuitable for individual investors.
3. Fully Taxable
According to local and state regulations, agency bond issuers like GSE companies Freddie Mac and Fannie Mae are fully taxable. Tax laws apply to capital gains or losses when selling agency bonds.
Researched and authored by Rishav Toshniwal | LinkedIn
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