Agency bonds are a type of bond issued or backed by a federal government agency or by a government-sponsored enterprise (GSE).
Investing in agency bonds, or “agencies,” can help with diversification that provides tax advantages. Understanding how agency bonds work, along with their advantages and disadvantages, can help you to decide whether to include them in your portfolio.
Definition and Example of Agency Bond
An agency bond is a bond that's issued by or guaranteed by U.S. federal agencies or government-sponsored enterprises. A GSE is a corporation that's created by Congress to fulfill a specific purpose, such as promoting affordable housing.
- Alternate name: Agencies, agency debt
When an agency bond is issued by a federal agency, it's with the full faith and credit of the U.S. government. This means that the government is committed to ensuring that investors receive interest payments from the bonds, along with the return of the principal they invested. As a result, agency bonds are considered to have low credit risk.
Agency bonds issued by a GSE don't have the same full faith and credit backing as the backing of the federal government. That means investors may assume a higher degree of credit risk when adding these bonds to their portfolios.
A wide variety of organizations can issue agency bonds and GSE bonds. Examples of federal entities that can issue agency bonds include the Federal Housing Administration (FHA) and the Government National Mortgage Association (Ginnie Mae). Examples of government-sponsored enterprises that can issue agency bonds include the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage (Freddie Mac).
Some agency bonds are callable, meaning they can be redeemed prior to maturity at the discretion of the bond issuer.
How Agency Bonds Work
A bond is a type of debt security. When an investor purchases a bond, they're agreeing to lend the bond issuer their capital for a set time period. In exchange, the bond issuer agrees to repay the principal along with interest payments.
Agency bonds work this way: An investor purchases the bond with the expectation that they'll be paid interest and receive their principal back at maturity. What differentiates agency bonds from other types of bonds is the entity that's issuing them, as well as the minimum investment that's required and their tax treatment. Again, agency bonds are issued by federal government agencies or GSEs.
Agency bond interest rates are set when the bond is originated and are determined by the issuer.
Most agency bonds offer a fixed coupon rate, though some can offer a floating rate. This rate is tied to a benchmark rate such as the six-month Treasury bill rate. As this benchmark rate adjusts up or down, the floating rate can follow suit. The typical minimum investment is $10,000 in an agency bond, with subsequent investments available in $5,000 increments.
Tax treatments for bond interest payments can vary among agency bonds. Agency bonds issued by the Federal Agricultural Mortgage Corporation (Farmer Mac), for example, are fully taxable. So are Freddie Mac and Fannie Mae agency bonds. But bonds issued by the Federal Farm Credit Banks Funding Corporation (Farm Credit) and Federal Home Loan Banks (FHL) are state and local tax-exempt.
Some agency bond issuers and GSEs can also issue no-coupon discount notes or step-up notes. A no-coupon discount note or "disco" is typically designed to help raise capital for short-term financing needs. Step-up notes have a coupon rate that increases or "steps up" over time, according to a predetermined schedule.
Advantages and Disadvantages of Agency Bonds
Investing in agency bonds can offer some unique benefits to investors, starting with the potential to generate higher yields than other Treasury securities. This owing to the fact that they're typically less liquid than other types of government bonds.
Generally, bond issuers that have higher credit ratings are considered to be less likely to default on making interest payments or returning principal to investors at the bond's maturity date. Agency bonds and GSE bonds tend to be of high credit quality, which is important for managing default risk.
Tax treatment of income from interest on agency and GSE bonds can be favorable, depending on the bond issuer. That's important if you're hoping to minimize tax liability on your investments. Consult a financial advisor or tax professional for guidance with determining how much tax benefit you're likely to see from specific agency bond investments.
In terms of risks, investors should be aware of the common risks of bonds in general. The main risks associated with agency bonds include:
- Call risk: This is the risk that an agency bond issuer will retire the bond ahead of its maturity date.
- Credit/default risk: Credit risk is a measure of how likely a bond issuer is to default on their obligation to repay investors.
- Inflation risk: Rising prices for consumer goods can threaten investors' purchasing power if the rate of return from an agency bond is outpaced by the inflation rate.
- Interest rate risk: Like other types of bonds, agency bonds are susceptible to the risk posed by fluctuating interest rates.
If you're ready to invest in agency bonds, it's possible to do so through an online brokerage account. Before purchasing agency bonds, it's helpful to review the minimum investment required and the maturity term, just as you would with other types of bonds. You can also review the credit profile of the bond issuer to determine what type of credit risk is involved.
- Agency bonds are bonds issued or guaranteed by federal agencies or government-sponsored enterprises (GSEs).
- Investing in agency bonds can help to diversify a portfolio while potentially generating slightly higher yields than Treasury bonds.
- Agency bonds and GSE bonds do have risks to consider, like credit risk, call risk, and inflation risk.