What Is Agency Security?
An agency security is a low-risk debt obligation that is issued by a U.S. government-sponsored enterprise (GSE) or other federally related entity. Agency securities are issued by GSEs which include the Federal National Mortgage Association (FNMA), Federal Home Loan Bank, Federal Home Loan Mortgage Corporation (FHLMC), the Student Loan Marketing Association (SLMA).
Agency Security Explained
Government-sponsored enterprises (GSEs) were created to reduce the costs associated with borrowing for certain sectors of the economy. For example, Federal National Mortgage Association (known as Fannie Mae) was introduced to improve the flow of credit in the housing economy. The Federal Agricultural Mortgage Association (Farmer Mac), a farming GSE, guarantees the timely repayment of principal and interest to agricultural bond investors. When a GSE issues a loan in the form of a bond, the security is referred to as an agency security.
There are two types of agency securities – federal government agency bond and GSE bond. Federal government agency bonds are issued by the Federal Housing Administration (FHA), Small Business Administration (SBA), Tennessee Valley Authority (TVA), and Government National Mortgage Association (GNMA). GNMAs are commonly issued as mortgage pass-through securities. Like Treasury securities, federal government agency securities are backed by the full faith and credit of the U.S. government, with the exception of securities of TVA. An investor expects to receive regular interest payments from holding this agency bond. At maturity, the full face value of the agency bond is remitted to the bondholder. Because federal agency bonds are less liquid than Treasury bonds, they offer a slightly higher rate of interest than Treasury bonds. In addition, federal government agency bonds may be callable, which means that investors are exposed to the risk that the issuer may redeem the bonds prior to their scheduled maturity date.
A Government-Sponsored Enterprise (GSE) bond is an agency bond issued by such agencies as Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage (Freddie Mac), Federal Farm Credit Banks Funding Corporation, and the Federal Home Loan Bank. GSE agency bonds are not backed by the same guarantee as federal government agencies and, hence, have credit risk and default risk. For this reason, the yield on these bonds is typically higher than the yield on Treasury bonds.
Most agency securities pay a semi-annual fixed coupon and are sold in a variety of increments, though the minimum investment level is generally $10,000 for the first increment, and $5,000 increments thereafter. GNMA securities come in $25,000 increments. Some agency bonds have fixed coupon rates while others have floating rates affixed to the bonds. Floating rate agency bonds have their interested rates periodically adjusted to the movement of a benchmark rate, such as the London Interbank Offered Rate (LIBOR). In order to meet short-term financing needs, some agencies may 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 prior to maturity, may result in a loss for the agency bond investor.
The interest from most, but not all, agency securities 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, Federal Home Loan Banks, and Federal Farm Credit Banks agency bonds are exempt from local and state taxes. In addition, agency securities are exempt from registration with the Securities and Exchange Commission (SEC) and are issued on a regular basis.