In the world of fixed-income securities, agency bonds represent one of the safest investments, and are often compared to Treasury bonds (T-bonds) for their low risk and high liquidity. But unlike Treasury bonds, which are issued only by the Department of the Treasury, agency bonds come from several sources, including not only government agencies, but also certain corporations granted a charter by the government. In this article we'll look at different types of agency debt, the tax issues involved with each and see the plethora of options available to individual investors looking for unique bond structures.
Agency Bond Issuers
Not all agency bonds are issued by government agencies; indeed, the largest issuers are not agencies per se, but rather government sponsored entities (GSEs). This is an important distinction, as true agencies are explicitly backed by the full faith and credit of the U.S. Government (making their risk of default virtually as low as Treasury bonds), while GSEs are private corporations that hold government charters granted because their activities are deemed important to public policy.
Among other things, these corporations provide home loans, farm loans, student loans and help finance international trade. Because the government places special emphasis on these activities by granting charters in the first place, the market generally believes that the government would not allow charterholding firms to fail - thus providing an implicit guarantee to GSE debt. Although agency bond traders recognize this distinction between true agencies and GSEs when buying or selling bonds, nevertheless yields for both types of debt tend to be virtually identical.
In the table below, we see two hypothetical agency bonds that are offered for sale by a bond dealer. Federal Farm Credit Bank (FFCB) is a GSE, thus carrying an implicit guarantee on its debt, while Private Export Funding Corp. (PEFCO) bonds are backed by U.S. government securities (held as collateral), and the interest payments are considered an explicit obligation of the U.S. government. Yet in the yield-to-maturity (YTM) line, one can clearly see that, within the marketplace, both implicit and explicit guarantees are valued very similarly, resulting in nearly identical returns.
|--||Agency Bond 1||Agency Bond 2||Treasury Bond|
|GSE or Agency||GSE||Agency|
Although they carry a government guarantee (implicit or explicit), agency bonds trade at a yield premium (spread) above comparable Treasury bonds. In the example above, the FFCB bond is offered at a 23 basis point spread (4.76% - 4.53% = 0.23%) over the Treasury bond, and the PEFCO bond at just over a 22 basis point spread.
There are a couple reasons why investors should expect this higher yield in agency bonds over Treasuries:
- There is some additional risk, however slight, stemming from political risk that the government guarantee of agency debt could be modified or revoked in the future, leaving the bonds more susceptible to default.
- Treasury bonds are arguably the most liquid financial instrument on the planet, and are used by central banks and other very large institutions requiring the ability to buy or sell securities in vast quantities very quickly and efficiently. Agencies, on the other hand, are neither quite as liquid nor as efficient to trade.
For example, if a large fund or government wishes to purchase $1 billion of 10-year bonds, it could easily fill the order using Treasury bonds, perhaps even finding that amount in a single bond issue, but if it instead attempted to buy agency bonds, the order would have to be split up into many smaller blocks of various issues, meaning more time spent and a less efficient process in general. Of course, for individual investors purchasing much smaller quantities, this is generally not a problem.
State Tax Issues
For any investor living in a state that imposes its own state tax on top of federal tax, perhaps the most critical issue is varying state taxability among agency bonds. While coupon payments on debt from the most well-known agencies (Fannie Mae and Freddie Mac) are taxable on both the federal and state level, other agencies are taxable only on the federal level.
Counterintuitively, the yields found on both fully taxable and state-tax-free agency bonds tend to be very similar, if not equal. While one might assume agency bonds that are not taxed at the state level would be more expensive than those that are fully taxable, (thereby offsetting part of the benefit - as is the case with municipal bonds, which are generally more expensive due to their privileged tax status), this is not always the case.
|--||Agency Bond 1||Agency Bond 2||Treasury Bond|
|Issuer||Fannie Mae||FHLB||U.S. Treasury|
|Fully Taxable or State Tax Free||Fully Taxable||State Tax Free|
Because the pre-tax yields on both fully taxable and state-tax-free agency bonds are generally nearly identical, it is critical to purchase state-tax-free bonds in accounts subject to state income taxes.
To illustrate this point, the table below shows how cash flows are affected by federal and state taxes. In this example we pay $100 (par value) for a two-year agency bond with a 6% annual coupon, then hold it to maturity. Assume you are in the 35% federal tax bracket, and that you live in California, where the state income tax rate is 9.3%.
* Federal tax is lower due to the deduction of state taxes
If the bond we purchased is state-tax free, our internal rate of return (IRR) net of taxes will be 3.9%, but if we mistakenly buy a bond subject to state tax, our return falls by 36 basis points to 3.54%.
Choose the Bond Structure Right for You
Some agencies issue a lot of debt. For example, Federal Home Loan Banks issued $322.5 billion worth of bonds in 2006. While there is plenty of plain vanilla debt issued, a surprising amount is structured in more exotic ways, and can satisfy specific needs of investors.
A large portion of agency debt is callable, which can be a good investment if you think yields are likely to rise. Since callable bonds contain an embedded call option (exercisable by the seller), they generally carry higher yields to compensate for the risk of the bond being called. Some callable agency bonds are callable at any time, while others are monthly, quarterly or even on only one specific date prior to maturity. Alternatively, some agency bonds are issued with a put provision exercisable by the bond holder, which can benefit the purchaser if yields rise.
Although embedded calls and puts are perhaps the most important and most common provisions to identify when purchasing bonds, there are many other structures and provisions to look for as well. Somewhat common is a step-up structure, in which the coupon rises as the bond approaches maturity. Step-ups are often attached to callable bonds, making them more likely to be called as the coupon rises (since the issuer is more likely to retire the debt when it has a larger coupon to pay).
Floating-rate bonds are also issued, on which the coupon resets periodically to a rate tied to LIBOR, Treasury bond yields, or some other specified benchmark. Other coupon variations are available, including monthly coupon payments, or interest-at-maturity bonds (akin to zero-coupon bonds). Also available are bonds carrying a death-put provision, in which the estate of a deceased bondholder may redeem the bond at par.
The Who's Who Of Agency Bonds
Below is a table showing basic information about each issuer. The top four make up over 90% of total agency debt outstanding, and are the most common issuers investors will come across when purchasing bonds.
|Symbol||Full Name||GSE/Agency||Coupon IncomeState Taxable|
|FHLB||Federal Home Loan Banks||GSE||No|
|FHLMC||Federal Home Loan Mortgage Corp. (Freddie Mac)||GSE||Yes|
|FNMA||Federal National Mortgage Association (Fannie Mae)||GSE||Yes|
|FFCB||Federal Farm Credit Banks||GSE||No|
|REFCORP||Resolution Funding Corp.||GSE||No|
|TVA||Tennessee Valley Authority||GSE||No|
|PEFCO||Private Export Funding Corp.||Agency||Yes|
|GTC||Government Trust Certificates||GSE||Yes|
|AID||Agency for International Development||Agency||Yes|
|FAC||Financial Assistance Corp.||Agency||No|
|GSA||General Services Administration||Agency||No|
|SBA||Small Business Administration||Agency||Yes|
|USPS||U.S. Postal Service||GSE||No|
Agency bonds give individuals and institutions the opportunity to gain a higher return than Treasury bonds, while sacrificing very little in terms of risk or liquidity. In addition, the multitude of bond structures found in agency offerings allow buyers to tailor their portfolios to their own circumstances.