Agency Bond

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. Agency bonds are subject to interest rate, liquidity, reinvestment, credit, call, inflation, market, and other macro event risks similar to other fixed-income securities.

Agency bond is a type of debt securities that can be issued by either the federal agencies of the United States or by the different government sponsored enterprizes (GSEs). But they are backed by the US government.

The US government has created GSEs to support certain sectors like agriculture or housing and include organizations like Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corporation), etc. These entities issue such bonds to meet their own financial requirements.

A government agency bond typically finances project-related needs or the overall operational need of enterprises. Investors who purchase these bonds are lenders who receive interest payments periodically and get their principal back at maturity in return for their investments.

They are considered relatively safe investments since the US government backs them. Investors perceive them to have a lower risk of default. Investors in a federal agency bond may include individuals, institutional investors, and foreign governments who wish to diversify their portfolios and earn regular income through interest. However, such agency bond yields are more than a treasury bond.

The following are the type of government agency bond.

#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

The GSEs 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 loss 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 liquidity to capital markets types. In this regard, they invest in capital stock and debt securities, guarantee MBS, purchase loans and hold them in their portfolio, and collect fees for guarantee and other services.

Some important features of these types of bonds are as follows:

• Fannie Mae and Freddie Mac are highly exposed to the mortgage-backed securities market. When mortgage defaults rose during the subprime mortgage crisis, 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.
• The Federal Government made significant cash injections into both Fannie Mae 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.

The following details will explain the various types of structures possible in case 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 LIBOR, EURIBOR, according to a predetermined formula.
• Zero-coupon agency bond is issued by agencies to meet short-term financing 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 agency bond rates i.e., when interest rates increase, agency bond prices fall and vice versa. These bonds are different from others as issuers can call the bond prior to maturity at the 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.

The bonds issued by the Federal national mortgage association (Fannie Mae), Federal home loan Mortgage (Freddie Mac), Federal farm credit banks, Funding corporation, and Federal home loan bank are some prominent examples.

The agency bonds issued by the Farm Credit System also fall in this category. They are an independent Federal agency and a lending institution who give credit who give credit to farmers and agricultural entities.

Understanding the advantages and disadvantages of investing in any financial instrument is necessary. Let us know the advantages of this type of federal agency bond.

• 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 risks because they are issued and guaranteed by a government agency and carry an implicit and explicit government guarantee. They also guarantee both interests,as well as principal payments 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 agency bond 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.

The disadvantages of investing in them are given below:

• 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 issuers 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.

The two types of bonds above are debt securities issued by the United States, but they have some critical differences. Let us identify them.

• The former is issued by the GSEs whereas the latter is issued by the US department of Treasury, which is on behalf of the US government.
• The former is not directly backed by the US government but has the support of the government in various degrees, but the latter has the support of the federal government in full faith and credit.
• The safety level of the former is considered less than the latter, which is totally backed by the US government.
• The former has lower level of liquidity and a smaller market as compared to the latter. Treasury bonds are very active in the secondary market.
• The agency bond yields are comparatively more than the latter because the latter has no risk, resulting in lower compensation for the investors.

Thus, the above are some important differences between the two types of bonds.