What are agency bonds?
Quick Take on Fixed Income
November 2015
Question: What are agency bonds?
Answer: Agency bonds are securities issued by two types of entities: 1) government-sponsored enterprises (GSEs), which usually are federally chartered but privately owned corporations; and 2) federal government agencies which issue bonds to finance activities related to public purposes, such as increasing home ownership or providing agricultural assistance.
Because of their government affiliation, agency bonds are secure, essentially backed by the full faith and credit of the U.S. government. These agencies receive favorable treatment in several arenas: they receive lower interest rates on money they borrow, have lower capital requirements, and are exempt from most state and local taxes. As a result, government agencies can offer investors more favorable bond earnings than would otherwise be possible.
Agency bonds issued by GSEs include bonds from the Federal Home Loan Mortgage Corp. (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Banks and the Federal Farm Credit Banks. GSEs are not backed by the full faith and credit of the U.S. government, unlike U.S. Treasury bonds. They do, however, carry an “implied guarantee” meaning the market believes these agencies would be bailed out by the U.S. government in the event of insolvency. This guarantee was tested in 2008 when both Freddie Mac and Fannie Mae were taken over by the U.S. Treasury after experiencing catastrophic losses on their mortgage portfolios.
Agency bonds issued by federal government agencies carry the full faith and credit of the U.S. Treasury. Federal government agencies include the Small Business Administration, the Federal Housing Administration and the Government National Mortgage Association (Ginnie Mae).
How do they trade?
Due to the agencies’ implied or explicit backing of the U.S. Treasury, they tend to trade fairly close to their Treasury counterparts. Because most agency securities are issued by the big four GSEs listed above, they carry only an implied backing of the U.S. Treasury. This means they trade at a slight spread to their Treasury counterparts, usually 5–10 basis points.
How are they taxed?
All agency bonds are taxable at the federal level, but the state taxation varies by issuer. For example, interest income from some agency bonds, such as those issued by Federal Farm Credit Banks and Federal Home Loan Banks, is exempt from state and local tax. The interest income from bonds backed by Fannie Mae and Freddie Mac, however, is not exempt from state and local tax.
In summary, agency bonds can offer a strong alternative to U.S. Treasury securities for investors looking for safety as well as yield, due to their strong credit quality and higher yields than Treasuries.
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