Agency bonds are debt securities issued by government-sponsored enterprises (GSEs) and government agencies. In this article, we will examine what agency bonds are, their key characteristics, how they differ from Treasury bonds, the major issuers of them, and factors to consider when investing in them.
What Are Government-Sponsored Enterprises?
Government-sponsored enterprises, or GSEs, are financial institutions created by the US government to enhance the flow of credit to specific economic sectors. They are privately owned but have implicit government backing. This backing gives agencies implicit government credit ratings, allowing them to borrow money at slightly higher rates than Treasury bonds but lower than other corporations.
The two largest agencies in terms of outstanding debt are Fannie Mae and Freddie Mac. They were created by Congress to enhance the availability of mortgage loans. Fannie Mae and Freddie Mac purchase mortgages from lenders, bundle them into mortgage-backed securities (MBS) and sell them to investors. This process provides lenders with funds to make more loans.
Other major GSE issuers include the Federal Home Loan Banks, the Federal Agricultural Mortgage Corporation (Farmer Mac), and the Student Loan Marketing Association (Sallie Mae). Each has a specific mission focused on providing liquidity and credit support in housing, agriculture, or education.
What Are The Key Characteristics of Agency Bonds?
Some key characteristics that differentiate agency bonds from other fixed-income securities:
- Credit risk: Agency bonds carry minimal credit risk due to implicit government backing. They are considered virtually risk-free, on par with Treasury bonds.
- Yield: They typically offer a modestly higher yield than similarly dated Treasuries to compensate investors for lack of sovereign backing.
- Maturity: Most agency bonds have maturities ranging from 1-30 years. Some agencies also issue short-term discount notes.
- Liquidity: Agency bonds are very liquid and trade over the counter with competitive bid-ask spreads like Treasury bonds.
- Tax treatment: Interest income is exempt from state and local income tax like Treasuries. It is, however, taxed at the federal level.
- Callable feature: Many agency bonds are callable, meaning the issuer can redeem the bond at par value before the maturity date.
- Regulation: As GSEs, agencies are independent rather than direct government agencies subject to government oversight.
Major Issuers of Agency Bonds
The three largest agencies issuing debt in the US are:
Fannie Mae: Chartered in 1938, Fannie Mae is the oldest housing GSE. It holds over $3 trillion in MBS and is the largest issuer of agency debt, accounting for over 30% of the market.
Freddie Mac: Created in 1970, Freddie Mac is the second largest housing GSE with $3 trillion in MBS. Together with Fannie Mae, they securitize over half of new US mortgages.
Federal Home Loan Banks: Formed in 1932, the FHLBs are a cooperative of 11 regional banks that provide lending to thrifts and mortgage banks. As of 2022, the FHLB system held $1.3 trillion in assets.
Other prominent agency issuers include the Federal Farm Credit Banks, Federal Agricultural Mortgage Corporation, Tennessee Valley Authority, and Financing Corporation. Combined, agency debt outstanding totals over $5 trillion, demonstrating their systemic importance to US credit markets.
What’s The Difference Between Agency Bonds And Treasury Bonds?
The largest differentiator between agency and Treasury bonds is credit risk. Agencies carry marginal credit risk compared to zero for Treasuries due to implicit government backing. As a result, yields on similarly dated agency bonds are typically 10-30 bps higher than comparable Treasuries.
Credit ratings for large issuers like Fannie/Freddie are AA+ compared to AAA for Treasuries due to private ownership. Agencies are subject to calls whereas Treasuries are non-callable, reducing reinvestment risk. However liquidity is comparable, but Treasuries experience lower volatility in distressed markets due to perceived safety.
Otherwise, agencies and Treasuries share similarities in terms of tax treatment, maturity ranges, and how they trade over the counter. With comparable yields, liquidity, and risks, agency bonds offer diversification benefits alongside Treasuries in investment portfolios.
What Are The Benefits of Investing in Agency Bonds?
There are several potential benefits for investors choosing to hold agency bonds in their portfolio:
- Safety: As GSE debt, agency bonds entail very low credit risk and default risk compared to other fixed-income sectors.
- Liquidity: Large issue sizes and trading volumes provide excellent liquidity, making it easy to buy and sell when needed.
- Yield potential: Slightly higher yields compared to Treasuries offer some compensation for marginal additional risk.
- Market sensitivity: Prices tend to move in line with Treasuries, providing a hedge against changes in risk-free rates.
- Diversification: Agencies complement Treasuries and broaden fixed-income exposure beyond just sovereign debt.
- Callable feature: Redemption income can boost total returns when bonds are called.
For these reasons, agency bonds may represent an attractive fixed-income option, especially for conservative investors seeking higher yields than Treasuries with minimal incremental credit risk.
What Are The Drawbacks
While there are advantages, some factors investors should be aware of include:
- Potential government intervention: Agencies could face tighter regulation, restructuring, or transition away from implicit backing risk.
- Prepayment risk: Early principal repayment impacts interest income for longer-dated bonds when rates decline.
- Inflation risk: Higher inflation may erode the real value of agency bond coupons over the long run.
- Liquidity concerns: Significant outflows could temporarily impact liquidity in volatile markets.
- Callable risk: Bonds may be called away before maturity, shortening expected maturity.
Understanding these nuances is important for investors evaluating the risk-return tradeoff of agency vs. Treasury bonds or other alternatives in diversified portfolios. Overall, though, agency bonds remain a low-risk fixed-income sector.
Conclusion
In conclusion, agency bonds play an important role in US financial markets by enhancing the availability of credit for housing, agriculture, and education. As high-quality debt securities issued by GSEs, they offer near-treasury yields with minimal credit risk. For conservative investors seeking exposure beyond Treasuries, agency bonds can represent an attractive fixed-income investment option. With over $5 trillion outstanding, they are a cornerstone of the global fixed-income markets.
