Agency bonds are a type of debt security issued by government-sponsored enterprises (GSEs) or certain federal government departments, excluding the U.S. Treasury. These bonds play a crucial role in the investment landscape, offering a blend of safety and potential returns. However, unlike U.S. Treasury and municipal bonds, not all agency bonds are fully backed by the federal government. This distinction is important for investors, as it influences both the risk and return profile of these securities. Understanding how agency bonds work, their types, characteristics, and associated risks can help investors make informed decisions that align with their financial goals.
What are Agency Bonds?
An agency bond is a type of debt security issued either by any government-sponsored enterprise or by the department of the federal government, excluding the U.S. Treasury. Unlike most of the U.S. Treasury and municipal bonds, some agency bonds do not have full backing from the federal government, and hence their risk profile differs based on the issuer. This distinction should be kept in mind by the investor, for it can affect not only the security but also the return of his investment.
How Agency Bonds Work?
Most agency bonds have a semiannual fixed coupon, although most of them sell in denominations, the yield of $10,000 initial investment and $5,000 additional increments. However, GNMAs are sold in $25,000 increments. Many agency bonds pay a fixed coupon rate although some feature floating rates that may adjust on a periodic rate according to the benchmark rate, for instance, LIBOR. Like all bonds, agency bonds carry the interest rate risk – if interest rates rise after purchase, the real spending power of the bond falls and the investor misses the potentially higher returns. This risk is particularly acute for the long-term.
Types of Agency Bonds
Another feature of the bonds issued to as less than a year or as large as 30 years in maturity is the fact that they come in many structures. The most common types are explained as follows:
Short-term Notes: These have a maturity of one year or less, providing a quick return. These also bear less interest rate risk.
Medium-term notes: These are one-to-10-year bonds that balance the return to risk ratio. They are likely to be purchased by investors who seek investments related to moderate risk.
Callable bonds: A callable bond is an issue where the issuer has the right to repay this debt before the maturity date. Thus, on a decline in interest rates, an issuer can refinance at a lower rate by calling bonds issued at a higher interest rate.
Fixed coupon bonds: These are bonds that have a pre-set interest rate, payable throughout life, and offering predictable income to any investor.
Also, the agency bond market comprises the following:
Floaters: This kind of bond bears a floating coupon payment, and the interest rate is reset, based on benchmark at the appropriate time, for instance, LIBOR, in order to protect against rising rates.
Zero-coupon discount bonds: Bonds of this type are issued at a discount to the face, and do not pay a periodic interest. The investor gets the full face value at maturity, with the return provided by the difference between the purchase price and the maturity value.
Characteristics of Agency Bonds
Agency bonds have several key characteristics that make them attractive to investors:
- Low Risk: Agency bonds are generally considered very safe investments, often carrying high credit ratings. Although not all are fully backed by the U.S. government, they still offer a strong degree of security.
- Higher Returns: Compared to U.S. Treasuries, which are considered risk-free, agency bonds typically offer higher returns, providing investors with better yield potential in exchange for slightly higher risk.
- High Liquidity: These bonds are actively traded in the market, making them highly liquid and easy to buy or sell without significant price fluctuations.
- Diverse Maturities: Agency bonds are available in a wide range of maturities, from less than a year to 30 years, allowing investors to choose bonds that match their investment time horizon.
- Variety of Structures: Investors can choose from various bond structures, including short-term and medium-term notes, fixed coupon bonds, callable bonds, floaters with variable interest rates, and zero-coupon bonds, catering to different investment strategies.
- Tax Advantages: Some agency bonds may offer tax benefits, such as exemption from state and local taxes on the interest earned, which can enhance their overall return
Advantages and disadvantages of agency bonds
Agency Bonds Advantages:
Low Risk: Generally, the agency bonds are considered a safe investment. This is normally supplemented by high credit ratings, which make them a sure deal for all conservative investors.
Higher Returns: When matched against the U.S. Treasuries, the agency bonds usually have higher returns in exchange for a little more risk.
High Liquidity: These bonds are easily tradable within the market, and there will not be much impact on price while buying or selling these securities.
Diverse Options: There are fixed and floating rate bonds; options range from short- to long-term bonds that let investors invest in securities that can best meet their strategy and goals.
Tax Benefits: A few agency bonds may benefit from tax exemption, such as state and local taxation on the interest earned, which enhances overall returns.
Disadvantages of Agency Bonds:
Interest Rate Risk: All bonds, which include agency bonds, are under threat from interest rate changes. If interest rates rise, this could lead to a fall in the price or value of the bond, more so in the case of long-term bonds.
Credit Risk: Although generally safe, not all agency bonds fully enjoy the backing of the US government; therefore, there is some credit risk involved depending on the issuer.
Lower Return Relative to Other Bonds: While they have higher yields than Treasuries, agency bonds usually offer lower returns compared to corporate bonds—and this could be unattractive for an investor seeking high income.
Call Risk: A few agency bonds, mainly callable bonds, carry an added call risk or early repayment from the issuer that will result in reinvestment at lower interest rates.
Complexity: Agency bonds have many structures and varied terms, thereby causing them to be complex and requiring that an investor fully understand the features and risks associated with a bond they intend to purchase.
Tax Considerations
Interest from most agency bonds is exempt from state and local taxes, but there are exceptions. Bonds issued by agencies like Farmer Mac, Freddie Mac, and Fannie Mae are fully taxable. Additionally, if agency bonds are purchased at a discount, investors may be subject to capital gains taxes upon selling or redeeming them, with gains or losses taxed at the same rates as stocks. On the other hand, agency bonds from the Tennessee Valley Authority (TVA), Federal Home Loan Banks, and Federal Farm Credit Banks are exempt from state and local taxes.
Bottom line
Agency bonds are debt securities issued by specific U.S. government departments and government-sponsored enterprises. While they aren't issued by the U.S. Treasury, they are generally regarded as extremely safe investments due to their low-risk profile. Investors can also opt for Compound real estate bonds as they are backed by US Treasuries and real estate providing security and high returns with an impressive fixed 8.5% APY.
