Agency Bond Definition
An agency bond is the bond issued by a government agency and tends to be relatively more liquid as compared to other bonds. However, they are typically less liquid than treasuries and do not have the same full federal guarantee. Agency bonds offer higher interest rates as compared to the treasury, while relative lack of liquidity may make them unsuitable for some investors.
Types of Agency Bonds
The following are the types of agency bonds.
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Source: Agency Bond (wallstreetmojo.com)
#1 – Issued by Federal Government Agency
These include the Federal housing administration (FHPA), Small business administration (SBA), Government national mortgage association ( GNMA or Ginnie Mae). Bonds issued by federal government agencies are generally guaranteed by the federal government, similar to treasuries.
#2 – Issued by Government Sponsored Enterprise
Includes the Federal national mortgage association (Fannie Mae), Federal home loan Mortgage (Freddie Mac), Federal farm credit banks, Funding corporation, and Federal home loan bank. GSE are quasi-governmental organizations created to enhance the availability of credit and reduce the cost of funding to targeted sectors of the economy.
This will eventually result in reducing the overall risk of capital lossCapital LossCapital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets.read more to investors. These entities are supervised but not directly managed by the federal government. These are privately owned and set up with a profit motive by providing liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more to capital markets typesCapital Markets TypesA capital market is a place where buyers and sellers interact and trade financial securities such as debentures, stocks, debt instruments, bonds, and derivative instruments such as futures, options, swaps, and exchange-traded funds (ETFs). There are two kinds of markets: primary markets and secondary markets.read more. In this regard, they invest in capital stockCapital StockThe capital stock is the total amount of share capital (including equity capital and preference capital) that has been issued by a company. It is a way of raising funds by the company to meet its various business goals.read more and debt securities guarantee MBS, purchase loans and hold them in their portfolio, and collect fees for guarantee and other services.
Features of Agency Bonds
- Fannie Mae and Freddie Mac are highly exposed to the mortgage-backed securities market. When mortgage defaults rose during subprime mortgageSubprime MortgageA subprime mortgage is a loan against property offered to borrowers with a weak or no credit history. Since the risk of recovering is high, the interest rate charged on such mortgages is higher so that the lender can recover a maximum amount at the beginning of the loan.read more crises, these entities experienced significant losses. Subsequently, their inability to raise capital and meet their obligation nearly led to collapse, which greatly disrupted the US mortgage lending and housing market. To avoid the eventuality, the US government forced them to a bailout.
- Ginnie Mae performs a similar function; however it is a federal government agency and hence enjoys full federal guarantee, whereas the other 2 entities do not. As GSE, they are independent and running for-profit entities. They do enjoy an implicit federal guarantee that encourages investors to offer more favorable terms. This was tested in the 2007 Subprime mortgage crisis.
- Federal Government made significant cash injections into both Fannie MaeFannie MaeFannie Mae, i.e., Federal National Mortgage Association is a United States government-sponsored enterprise (GSE) which was founded in the year 1938 by congress to boost the secondary mortgage market during the great depression which involves financing for the mortgage lenders thereby providing access to affordable mortgage financing in all the markets at all times.read more and Freddie Mac, and in Sep 2008, both entities were put into conservatorship.
- As a conservator, the US government and FHFA (which regulates the country’s secondary mortgage markets) have imposed various controls on these entities.
Structure of Agency Bonds
- Fixed coupon rate agency bonds: It pays a fixed rate of interest at regular intervals, such as quarterly or annually, semi-annually.
- Variable or floating coupon rate agency bonds: Where the interest rates are adjusted periodically. Adjustments are usually linked to some reference rates, such as yields on U.S. Treasury bonds or LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more, EURIBOR, according to a predetermined formula.
- Zero-coupon agency bond is issued by agencies to meet short-term financingShort-term FinancingShort-term financing refers to financing a business for less than a year in order to generate cash for working and operating expenses, usually for a smaller amount. It include obtaining funds through online loans, credit lines, and invoice financing.read more needs and is issued at a discount at initiation and redeemable at par during maturity.
- Callable agency bonds: Most of them are non-callable and are sensitive to changes in interest rates i.e., when interest rates increase, agency bond prices fall and vice versa. These bonds are different than others as issuers can call the bond prior to maturity at call price, which is lower than the current market price. This usually happens at a time when interest rates are declining as the issuer has an option to call back the previous higher interest rate bonds by borrowing at the lower interest rate and using the proceeds to pay back investors.
Advantages of Agency Bonds
- Less credit risk: Although they do not carry the full faith and credit guarantee of US government agency bonds are perceived to carry lower credit risksCredit RisksCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more because they are issued and guaranteed by a government agency and carry an implicit and explicit government guarantee. They also guarantee both interests,s as well as principal paymentsPrincipal PaymentsThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.read more of the securities they sell. Together these entities guarantee half of the USD 12 trillion outstanding mortgages in the US.
- Higher return: They provide more favorable borrowing rates than any other type of bond due to the higher credit risks attached.
- Favorable source of finance: These bonds help to finance projects relevant to public policy such as agriculture, small business, or loan to home buyers. They provide support to sectors of the economy that might otherwise struggle to find affordable sources of funding.
- Infuse Liquidity: Fannie Mae and Freddie Mac support liquidity in the US housing market. Specifically, they purchase mortgages from lenders such as banks and repackage them into securities and further sell them to investors.
- Exemption from local taxes: The interest from most agency bond issues is exempt from state and local taxes, but it is important for investors to understand the tax consequences before investing in it.
- Higher Credit rating: As the issuing agency backs an agency bond, they are able to receive a high credit rating by recognized rating agencies and hence are viewed by some as moral obligations of the federal government.
Disadvantages
- Minimum capital requirement: There is a limitation on minimum capital amount to be invested in agency bonds i.e., a minimum investment of $25,000 is required in Ginnie Mae Agency bonds, which means an investor with small investment portfolios cannot invest in these bonds.
- Complex in nature- Some agency bond issues have features that make them more “structured” and complex in nature which further reduces the liquidity of these investments and makes them unsuitable for individual investors.
- Fully Taxable-Agency bond issuersBond IssuersBond Issuers are the entities that raise and borrow money from the people who purchase bonds (Bondholders), with the promise of paying periodic interest and repaying the principal amount when the bond matures.read more such as GSE entities Freddie Mac and Fannie Mae are fully taxable as per local or state regulation. Capital gains or losses when selling agency bonds are tax as per tax regulations.
Conclusion
Agency bonds are subject to interest rate, liquidity, reinvestmentReinvestmentReinvestment is the process of investing the returns received from investment in dividends, interests, or cash rewards to purchase additional shares and reinvesting the gains. Investors do not opt for cash benefits as they are reinvesting their profits in their portfolio.read more, credit, call, inflation, market, and other macro event risks similar to other fixed-income securities.
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