If you’re familiar with government bonds, you’ve probably heard of agency bonds as well. What is an agency deposit? These bonds originate from a government backed entity and typically pay a higher interest rate than treasury bills. However, they are not always backed by the full confidence and credit of the United States government. Agency bonds tend to be popular debt securities for larger funds because their rate of return tends to be better than Treasury bills.
Agency bonds are not something most individual investors hold, as they are issued in $ 5,000 increments, starting with a $ 10,000 investment. Most pay a semi-annual fixed coupon, at a fixed or variable rate, depending on the bond. Here’s a look at what they are, how they work, and what makes them an attractive investment for funds.
What is an agency and how do agency obligations work?
An agency is a government organization or government sponsored entity (GSE) with the express purpose of improving society. It can encompass everything from affordable housing projects to agricultural developments. To finance these initiatives, organizations and GSEs issue debt, called Agency bonds.
Two of the largest GSEs to issue agency bonds are the housing authorities, Freddie Mac and Fannie Mae. They issue Mortgage Backed Securities (MBS), which are a form of agency bond. MBS are the most common type of agency bond; however, they are not the only ones. An entity like the Farm Credit System issues different types of debt securities to provide loans to farmers, such as crop insurance, which is another form of this type of bond.
Two types of agency obligations
While agency bonds represent a wide range of different debt securities, there are two main types of investors affected by:
- Obligations of federal government agencies. These agency bonds are mortgage-backed securities offered by the Federal Housing Administration (FHA), the Small Business Administration (SBA) and the Government National Mortgage Association (GNMA). They are backed by the full faith and credit of the United States government, making them extremely safe investments. That said, they are callable bonds and tend to be less liquid than Treasuries, while offering a slightly higher interest rate.
- Government sponsored corporate bonds. These obligations come from GSE and do not carry any warranty. Indeed, they do not come from government agencies, but only from those subject to government surveillance. They can include MBS and other forms of debt securities, and tend to vary widely in terms of rate and duration. They are more liquid than other agency bonds and offer a higher yield. Some are even offered as coupon-free discount notes, which offer even higher rates of return depending on maturity.
As mentioned, most agency bonds come with a high purchase price, making direct access impossible for most retail investors. Instead, direct purchases of agency bonds tend to come from institutions and managed funds. That said, retail investors may gain exposure to agency bonds through a broker or fund with these assets under management.
Agency bond structures to consider
Agency bonds have different structures depending on the issuer and the type of bond. Investors should pay close attention to the structure of bonds when investing, as it can dictate everything from the rate of return to the risk associated with the bond:
- Fixed coupon. These bonds pay a fixed coupon quarterly, annually or semi-annually.
- Floating coupon. Interest rates adjust over time and are usually tied to treasury bills.
- Zero coupons. Called “nightclubs”, they are sold at a reduced price and redeemable at maturity.
- Redeemable bonds. The issuer can call the bond early if interest rates fall.
Fixed coupon bonds represent the majority of the market; however, interest rate volatility may cause other types of bond structures to rise. Investors should study the landscape of interest rates and bond products to understand issuer sentiment before investing in these bonds.
The advantages and disadvantages of agency obligations
There are equal and compensating advantages and disadvantages for these obligations. They tend to be comparable to other large debt securities, including treasury bills. Here is a quick rundown of their advantages and disadvantages.
- Compared to corporate bonds, the debt risk associated with agency bonds is minimal.
- Most agency bonds, while not guaranteed by the United States, offer similar creditworthiness.
- Agency bonds, particularly those of GSEs, have a higher rate of return than Treasury bills.
- Most agency bonds have high liquidity which makes them an attractive investment.
- Interest payments on agency bonds may be exempt from state and local tax.
- Interest rate risk could cause interest rates to rise, thereby reducing the value of the bond.
- Although rare, the risk of default is a possibility for debt unsecured by the US government.
- The minimum capital requirements are high for direct exposure to these types of bonds.
- Bond structures can be complex for first-time investors or new investors in debt.
The bottom line is that these bonds tend to offer lower risk and higher reward for debt investors. They differ from corporate bonds by their solid nature, while maintaining a high level of liquidity not seen in treasury bills.
Should we invest?
When it comes to debt securities, these bonds offer a unique perspective. What is an agency deposit? For many, they represent the best of both worlds in debt investing: the safety of treasury bills and the return on investment of corporate bonds. But are they worth it?
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For individual investors, direct exposure is not often the order of the day. Instead, exposure to agency bonds through a fund is much more realistic. If you are looking for a balance or need a more conservative portfolio allocation, agency bonds are well worth the consideration.