Smart Bond Investing—Types of Bonds

Agency Securities

 

"Agencies" is a term used to describe two types of bonds: (1) bonds issued or guaranteed by U.S. federal government agencies; and (2) bonds issued by government-sponsored enterprises (GSEs)—corporations created by Congress to foster a public purpose, such as affordable housing.

 

Bonds issued or guaranteed by federal agencies such as the Government National Mortgage Association (Ginnie Mae) are backed by the "full faith and credit of the U.S. government," just like Treasuries. This is an unconditional commitment to pay interest payments, and to return the principal investment in full to you when a debt security reaches maturity.

 

Bonds issued by GSEs such as the Federal National Mortgage Association (Fannie Mae, the Federal Home Loan Mortgage (Freddie Mac) and The Federal Agricultural Mortgage Corporation (Farmer Mac) are not backed by the same guarantee as federal government agencies. Bonds issued by GSEs carry credit risk.

 

It is also important to gather information about the enterprise that is issuing the agency bond, particularly if it is issued by a GSE. Players in the agency bond market—Fannie Mae, Freddie Mac and Farmer Mac—are publicly traded companies who register their stock with the SEC and provide disclosures that are publicly available including annual reports, quarterly reports and reports of current events that stand to impact the company. These documents can give you insight into the economic health of the company, the challenges and opportunities it faces, and short- and long-term corporate goals. These company filings are available online on the SEC's website. It is important to learn about the issuing agency because it will affect the strength of any guarantee provided on the agency bond. Evaluating an agency's credit rating before you invest should be standard procedure.

 

On September 6, 2008, both Freddie Mac and Fannie Mae were placed into conservatorship by the Federal Housing Finance Agency (FHFA), which regulates the country’s secondary mortgage markets. As conservator, FHFA has ultimate control over the two organizations.

 

It takes $10,000 to invest in most agency bonds (Ginnie Maes are an exception, requiring a minimum investment of $25,000), with the majority of agency bonds paying a semiannual fixed coupon. There is a relatively active (liquid) secondary trading market for agencies, though it is important for investors to understand that many agencies are tailored to the needs of a particular investor or class of investors—with the expectation that they will be held until maturity. This is especially true of structured agency securities (agencies with special features, which are often not suitable for individual investors).

 

Most agency bonds pay a semiannual fixed coupon and are sold in a variety of increments, though the minimum investment level is generally $10,000 for the first increment, and $5,000 increments thereafter. The tax status of agency bonds varies. Interest from bonds issued by Freddie Mac and Fannie Mae is fully taxable, while those issued by some other GSEs offer state and local tax exemptions. Capital gains and losses on the sale of agency bonds are taxed at the same short- and long-term rates (for bonds held for one year or less or for more than one year) as for stocks.

 

Legal Name Common Name Tax Status
 Federal Agricultural Mortgage Corporation  Farmer Mac  Fully taxable
 Federal Farm Credit Banks Funding Corporation  Farm Credit  State and local exempt
 Federal Home Loan Banks  FHL Banks  State and local exempt
 Federal Home Loan Mortgage Corporation  Freddie Mac  Fully taxable
 Federal National Mortgage Association  Fannie Mae  Fully taxable
 Tennessee Valley Authority  TVA  State and local exempt

 

Types of Agencies

 

Agency bonds can be structured to meet a specific need of an investor, issuer or both.

 

For instance, in addition to the traditional coupon-paying agency bond, some organizations issue no-coupon discount notes—called "discos"—generally to help them meet short-term financing demands. This explains why disco maturities are usually quite short, ranging from a single day to a year. Discos resemble STRIPS in that they are zero-coupon securities that are issued at a discount to par. As with all bonds that trade at such a discount, if you sell the bond before it matures, you may lose money.

 

Another type of structured agency security is a step-up note, or "step-up." These securities are callable with a coupon rate that "steps up" over time according to a pre-set schedule. The goal of a step-up is to minimize the impact of interest rate risk. Provided the security is not called, the step-up will keep providing the bondholder with an increased coupon rate, cushioning the investor from interest rate risk. Step-ups are not problem-free, however, as they often offer limited call protection.

 

Yet another type of agency is a floating-rate security, or "floater." Floaters pay a coupon rate that changes according to an underlying benchmark, such as the six-month T-bill rate.

 

Keep in mind that such structured notes, and other esoteric products such as index floaters and range bonds, can be quite complicated and may be unsuitable for individual investors.

 

 

Agency Risk Report Card

  Green Checkmark Credit and default risk are real for GSE-issued agencies: The federal government is under no legal obligation to save a GSE from default.
  Green Checkmark Call risk: Many agency securities—step-ups in particular—carry call provisions that allow the issuer to pay you prior to the bond's maturity date, typically when interest rates drop, leaving you to reinvest at lower prevailing rates.
  Green Checkmark Interest rate risk: If interest rates rise, the value of an agency bond on the secondary market will likely fall.

 

 

Agency Bonds Snapshot

  Issuer Government-sponsored enterprises (GSEs)
  Minimum Investment Varies—generally $10,000
  Interest Payment Fixed coupon or floating/variable coupon rates. Interest is paid semiannually for fixed-coupon security.
  How to Buy/Sell Through a broker
  Bond Interest Rate Determined at origination and varies by bond
  Price Information Issue price and secondary trade data available through a broker and data vendors
  Website for More Info Securities Industry and Financial Markets Association (SIFMA)—The GSE Debt Market: An Overview

  • prev
    U.S. Savings Bonds
  • next
    Mortgage-Backed Securities