Agency Bonds 

Bonds are one of the most common investment strategies used by those looking for steady income and lower risk than equities. Among all fixed-income securities, agency bonds are considered an excellent option for beginner investors due to their association with government-affiliated organisations and relatively safer nature. This detailed guide will provide a comprehensive overview of agency bonds and simplify their complexities for new investors. 

What Are Agency Bonds? 

Agency bonds are debt securities issued by government-sponsored enterprises (GSEs) or federal government agencies (excluding the U.S. Treasury). They raise funds for specific sectors such as housing, agriculture, and infrastructure development. Unlike Treasury bonds, which are backed by the “full faith and credit” of the U.S. government, agency bonds may or may not have explicit government guarantees, depending on the issuer. 

Purpose of Agency Bonds 

The primary goal of agency bonds is to support public policy objectives. The funds raised through these bonds are channeled into sectors that benefit society as a whole, such as: 

• Affordable housing initiatives. 

• Agricultural development and farmer support. 

• Infrastructure improvements. 

For instance, GSEs like Fannie Mae and Freddie Mac issue bonds to ensure liquidity in the mortgage market, enabling more Americans to access home loans. 

Understanding Agency Bonds 

Agency bonds are distinct from other fixed-income securities in several ways. Below, we explore their fundamental characteristics and what makes them unique. 

Key Features of Agency Bonds; 

1. Issuer: Agency bonds are issued by either:

• Government-sponsored enterprises (GSEs): Privately-owned organisations created by Congress, such as Fannie Mae and Freddie Mac. 

• Federal agencies: Organisations like Ginnie Mae are directly affiliated with the U.S. government. 

2. Investment Denomination: Agency bonds are sold by the principal in denominations of $1,000 to reach a large investor base.

3. Maturity Period: These bonds are available in various maturities, from less than one year to up to 30 years so that investors can match their investments with their financial goals.

4. Coupon Payments: Agency bonds typically involve fixed payments, paid semi-annually. Some types of bonds have floating interest rates benchmarked to Treasury bill rates.

5. Risk and Yield: Agency bonds offer higher yields than Treasury securities but come with slightly higher risks, especially for GSE bonds without explicit government backing.

Types of Agency Bonds 

Agency bonds can be classified into two main categories based on the issuer. 

1. Government-Sponsored Enterprise (GSE) Bonds

GSEs are financial institutions created by Congress that keep vital economic sectors, like housing and agriculture, running. GSEs don’t have direct government guarantees but an implicit guarantee that comforts investors. The significant GSEs are: 

• Fannie Mae (Federal National Mortgage Association): Purchases mortgages from lenders, bundles them into mortgage-backed securities (MBS), and sells them to investors. 

• Freddie Mac (Federal Home Loan Mortgage Corporation): Like Fannie Mae, Freddie Mac focuses on ensuring liquidity in the residential mortgage market. 

• Federal Home Loan Banks: Advances funds to financial institutions for affordable home loans. 

• Federal Farm Credit Banks: Offers loans and financial services to agricultural producers and rural communities. 

2. Federal Government Agency Bonds

Unlike GSEs, U.S. government agencies are openly sponsored, meaning the bonds from such agencies enjoy the “full faith and credit” guarantee. This makes them extremely safe. Examples of federal agency bonds include: 

• Ginnie Mae (Government National Mortgage Association): Guarantees timely principal and interest payments on mortgage-backed securities. 

• Small Business Administration (SBA): Issues bonds to support small businesses across the United States. 

• Tennessee Valley Authority (TVA): Issues bonds to finance regional energy and infrastructure projects. 

How Do Agency Bonds Work? 

Agency bonds operate similarly to fixed-income securities but come with unique features due to their specific issuers and public-purpose objectives. Here’s a step-by-step breakdown of how these bonds function. 

1. Issuance

When a government-sponsored enterprise (GSE) or federal agency needs funding for public initiatives such as housing or infrastructure, they issue agency bonds. These bonds have predefined terms, including: 

• Face Value: The amount the bondholder will receive at maturity as the principal repayment. 

• Coupon Rate: The interest paid periodically yearly on the bond is payable in percent of its face value. 

• Maturity Date: This is when the principal sum will be paid back to the bondholder 

For instance, a bond with a face value of US$10,000 issued with a 4% coupon rate and matured after 10 years will put all this information in the offering statement so that no investor goes scot-free. 

2. Investor Buy

They lend money to the issuer and, by doing so, purchase agency bonds. They become entitled to a series of coupon payments in interest until the maturity date, on which they are repaid with the bond’s principal. 

Traditionally, the bonds are sold in increments of US$1,000, making them available to retail and institutional investors. 

3. Coupon Payments

Most agency bonds pay semi-annually, which ensures a steady stream of cash flows to the investors. The amount of interest payable is determined using the coupon rate and face value of the bond. 

For example, a US$10,000 bond with a 4% annual coupon rate would pay the following: 

The yearly interest would be US$400 because 4% of US$10,000 equals US$400. 

This would amount to paying US$200 every six months. Such regular payments make agency bonds attractive to income seekers. 

4. Callable Bonds

One point of interest regarding agency bonds is that most are callable. Callable bonds mean the issuer can redeem them before maturity, and callable bonds are quite prevalent among government-sponsored enterprises, especially Fannie Mae and Freddie Mac. 

For interest rates to fall, the issuers can call the bond so that it can refinance debt at a lower cost. It offers flexibility on the part of the issuer but brings reinvestment risk to the investors. Now, the investor can be forced to re-invest the returned principal at a lower yield, which would bring down overall income. 

Examples of Agency Bonds 

Real-life scenarios may be better understood by illustrating how agency bonds work. Below are two examples in detail from leading issuers, Fannie Mae and Freddie Mac: 

Example 1: Fannie Mae 10-Year Bond 

Issued by: Fannie Mae 

Date of Issue: January 1, 2025 

Maturity Date: January 1, 2035 

Coupon Rate: 3.5% 

Face Value: $10,000 

Interest Payment: Semi-annual, which is US$175 per payment. 

An investor holding this bond would earn US$350 in annual interest payments, split into two instalments of US$175 each. Over the 10-year term, they would receive US$3,500 in interest income. At maturity, the bondholder would be repaid the $10,000 principal amount, completing the investment cycle. 

Example 2: Freddie Mac 5-Year Callable Bond 

• Issuer: Freddie Mac 

• Issue Date: July 1, 2024 

• Maturity Date: July 1, 2029 

• Coupon Rate: 4% 

• Call Option: Redeemable after 3 years 

Now, Freddie Mac can redeem the bond after three years in case interest rates go down. For example, by 2027, if interest rates have reduced to 2%, Freddie Mac can call in the bonds, return the principal amount to the investor, and reissue its new bonds at such a reduced rate. 

While this benefits Freddie Mac by reducing its borrowing costs, it may disadvantage the investor, who would need to reinvest the returned principal in a lower-yielding investment. However, the investor would still receive the interest payments up to the call date. 

Frequently Asked Questions