They are a form of bond issued or guaranteed by an agency of the federal government or a government-sponsored entity (GSE). The investment in agency bonds, also known as "agencies," can help by diversifying your portfolio and offering tax benefits. Understanding how these bonds function and their benefits and drawbacks will help you determine whether to incorporate them into your portfolio.
Working
They are offered in various increments, with a minimum investment of $10,000 to purchase the initial increment and $5,000 for the subsequent increments. GNMA securities are available in increments of $25,000. Some agency bonds are fixed coupon rates, whereas others are floating rates. The interest rates on floating rate bonds of agencies are adjusted based on the fluctuation of the benchmark rate like LIBOR.
As with all bond types, these agency bonds come with the risk of interest rate increases. In other words, a buyer may purchase bonds only to see interest rates increase. The power to spend the bond is lower than it used to be. Investors could have earned much more by waiting until a greater interest rate started. Naturally, the risk is higher for bonds with long-term maturity.
Types of Agency Bonds
Federal Government Agency Bonds
Federal agency bonds are made by the FHA, SBA, and the GNMA. The GNMAs are typically issued as mortgage pass-through security. As with Treasury securities, Federal government agency bonds are insured by the complete credit and confidence that is the U.S. government. Investors receive regular interest payments while holding the bond of this agency. On the maturity day, the entire amount of the face value bond is paid back to the bondholder.
Federal agency bonds have an interest rate slightly higher than Treasury bonds due to be less liquid. Additionally, bonds issued by agencies could be callable; this means that the organization that issued them could decide to redeem them before their due date.
Government-Sponsored Enterprise Bonds
GSE is issued through entities like Fannie Mae, Freddie Mac, and Federal Home Loan Bank. They are not government-owned entities. These are private businesses with a public function which is why they are assisted by the government and under the supervision of the government.
GSE agency bonds don't offer the same backing from government agencies of the U.S. government as Treasury bonds or agency bonds issued by the government. This means that there is a certain risk of default and credit, and their interest rate tends to be higher. To meet the short-term needs of financing, certain agencies offer discount notes that do not have coupons, also known as "discos," at a discount of up to. They have maturities that range from a single day to one year. If they are sold before the maturity date, it could cause a loss for the bond buyer of the agency.
Tax Considerations
The interest on most of, but not all, government bonds is exempted from both state and local taxes. Farmer Mac, Fannie Mae and Freddie Mac agency bonds are tax-free. When they are purchased at a bargain price, it could cause investors to pay capital gains tax when they are traded or exchanged. Losses or capital gains in the sale of bonds issued by agencies are taxed at the same rate as stocks.
Right for You
Some organizations issue lots of debt. For instance, Federal Home Loan Banks issued $437.7 billion in bonds in 2020. While plenty of ordinary debt is issued, a surprising portion can be structured using more unusual ways to meet certain requirements of investors. A large proportion of agency debt can be called. It can be an investment worth considering if you think that yields are likely to increase because callable bonds have the option of calling (exercisable from the vendor) and are generally backed by higher yields to offset the possibility of being called.
Certain callable bonds from agencies are available anytime, while others are quarterly, monthly, or even on a particular date before maturity. Additionally, some bonds issued by agencies come with a put option that can be exercised by the bondholder, which could benefit the buyer when yields rise.
Although embedded calls and put are probably the most crucial and common features to look for when buying a bond, you must be aware of other types of structures and provisions you can consider. A common one is a step-up arrangement where the coupon increases as the bond get closer to its maturity. They are usually tied to callable bonds, which makes them more likely to be called once the coupon increases (since it is easier for an issuer to redeem the debt when it has a greater coupon to repay).
