What Is an Agency Bond?
An agency bond is a security issued by a government-sponsored enterprise or by a federal government department other than the U.S. Treasury. Some are not fully guaranteed in the same way that U.S. Treasury and municipal bonds are. An agency bond is also known as agency debt.
- Federal government agency bonds and government-sponsored enterprise bonds pay slightly higher interest than U.S. Treasury bonds.
- Most, but not all, are exempt from state and local taxes.
- Like any bonds, they have interest rate risks.
How Agency Bonds Work
Most agency bonds pay a semi-annual fixed coupon. They are sold in a variety of increments, generally with a minimum investment level of $10,000 for the first increment and $5,000 for additional increments. GNMA securities, however, come in $25,000 increments.
Some agency bonds have fixed coupon rates while others have floating rates. The interest rates on floating rate agency bonds are periodically adjusted according to the movement of a benchmark rate, such as LIBOR.
Like all bonds, agency bonds have interest rate risks. That is, a bond investor may buy bonds only to find that interest rates rise. The real spending power of the bond is less than it was. The investor could have made more money by waiting for a higher interest rate to kick in. Naturally, this risk is greater for long-term bond prices.
Types of Agency Bonds
There are two types of agency bonds, including federal government agency bonds and government-sponsored enterprise (GSE) bonds.
Federal Government Agency Bonds
Federal government agency bonds are issued by the Federal Housing Administration (FHA), Small Business Administration (SBA), and the Government National Mortgage Association (GNMA). GNMAs are commonly issued as mortgage pass-through securities.
Like Treasury securities, federal government agency bonds are backed by the full faith and credit of the U.S. government. An investor receives regular interest payments while holding this agency bond. At its maturity date, the full face value of the agency bond is returned to the bondholder.
Federal agency bonds offer a slightly higher interest rate than Treasury bonds because they are less liquid. In addition, agency bonds may be callable, which means that the agency that issued them may decide to redeem them before their scheduled maturity date.
Government-Sponsored Enterprise Bonds
A GSE is issued by entities such as the Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage (Freddie Mac), Federal Farm Credit Banks Funding Corporation, and the Federal Home Loan Bank.
These are not government agencies. They are private companies that serve a public purpose, and thus may be supported by the government and subject to government oversight.
GSE agency bonds do not have the same degree of backing by the U.S. government as Treasury bonds and government agency bonds. Therefore, there is some credit risk and default risk, and the yield offered on them typically higher.
To meet short-term financing needs, some agencies issue no-coupon discount notes, or “discos,” at a discount to par. Discos have maturities ranging from a day to a year and, if sold before maturity, may result in a loss for the agency bond investor.
Government-sponsored enterprise bonds do not have the same degree of backing by the U.S. government as Treasury bonds and other agency bonds.
The interest from most, but not all, agency bonds is exempt from local and state taxes. Farmer Mac, Freddie Mac, and Fannie Mae agency bonds are fully taxable.
Agency bonds, when bought at a discount, may subject investors to capital gains taxes when they are sold or redeemed. Capital gains or losses when selling agency bonds are taxed at the same rates as stocks.
Tennessee Valley Authority (TVA), Federal Home Loan Banks, and Federal Farm Credit Banks agency bonds are exempt from local and state taxes.