Agency Bonds and Government-Sponsored Enterprise (GSE) Bonds

Agency bonds are issued by agencies of the US government and GSE bonds are issued by government-sponsored enterprises, which are private corporations created by the federal government to promote socially desirable goals, such as providing low-cost loans for farmers and for lower income Americans to enable them to buy a home. The term agency bonds often refer to both types of bonds. Agency bonds are free or virtually free of credit default risk, and they pay a slightly higher interest rate than comparable Treasuries.

The 2 types of agency bonds are based on the type of issuers of these bonds. Some of these issuers are actual agencies of the US government. Other issuers are government-sponsored enterprises (GSEs), quasi-governmental entities established by Congress to enhance the flow of credit to specific sectors of the U.S. economy, not by lending money directly, but by guaranteeing 3^rd-party loans and purchasing those loans from loan originators, which are then securitized into bonds that are sold to investors.

To prevent a lot of repetition, I will refer to both agency bonds and GSE bonds as agency bonds, unless there is a specific reason to distinguish them.

Bonds issued directly by an agency of the federal government are backed by the full faith and credit of the US government, just like Treasuries. A common example of this type of security are the mortgage-backed securities issued by the Government National Mortgage Association, otherwise known as Ginnie Mae.

By contrast, GSE bonds have only implicit backing by the US government, meaning that most investors believe that the US government would not let GSE bonds default. The reason for this belief is that these bonds supply credit to several important industries, such as for farming and for housing. If a default would occur, and the government did not step in and make investors whole, then interest rates would rise on these types of bonds, making it more expensive to finance credit for these important industries. Consequently, GSE bonds are virtually risk-free, but since they are not completely risk-free, they pay a slightly higher interest rate. Some GSE bonds are not backed by the government, but are, instead, backed by the revenues generated by the projects financed by the bonds, such as the bonds issued by the Tennessee Valley Authority.

Has the government ever prevented the default of GSE bonds? Yes. Fannie Mae and Freddie Mac, GSEs that also issue mortgage-backed securities but do not have the explicit backing like the securities issued by Ginnie Mae, were, in fact, bailed out by the federal government when they were placed under a conservatorship in 2008, during the Great Recession, which has reinforced the belief that GSE bonds are implicitly backed by the federal government. The stockholders were wiped out. But the holders of the mortgage-backed securities issued by Fannie Mae and Freddie Mac did not suffer any credit losses despite substantial defaults by individual borrowers. This does not guarantee that the federal government will support GSE bonds in the future but considering the importance of these bonds to the economy, it is likely that such support will continue.

The major issuers of agency bonds, which includes the Federal Home Loan Banks, and Freddie Mac and Fannie Mae, and even includes the U.S. Postal Service, are displayed on the next page. Like Treasuries, the interest from all agency and GSE bonds are taxable by the federal government, and several types of these bonds, displayed in red, are also subject to state or local tax. But some GSE and agency bonds, displayed in black, are exempt from state and local taxes.

Agency and GSE bonds do have some interest rate risk when interest rates are low because bond prices decline when interest rates rise. The decline in price that occurred from 2021 to 2023 resulted from rising interest rates. However, when interest rates are high, that interest rate sensitivity translates into potential capital gains.

Unlike Treasuries, many agency bonds are callable. The earliest date that the bonds can be called is referred to as the call date, and most bonds can be called at any time after that date. Most agency bonds do not pay a call premium.

Bonds are more likely to be called if interest rates are lower on the call date or thereafter than when the bond was issued. Therefore, callable bonds have reinvestment risk, meaning that you may have to reinvest your money for a lower interest rate for the same amount of risk. However, longer-term callable bonds usually pay a higher rate of interest than comparable Treasuries because of their call risk.

For instance, in November 2023, a 20-year federal home loan bank bond that was callable only 6 months after the issue date was paying 6.82% while a 26-week Treasury bill was paying 5.494%, 1.326% lower than the callable bond. Here, the advantage of the agency bond is not only the higher interest rate over the 26-week T-bill, but you may earn the higher interest rate for a longer time since the bond will not be called until interest rates decline.

The callability feature of bonds will affect the price of the bond and change its yield. For most agency bonds, the call price = face value. Long-duration bonds have a greater capital gain potential when interest rates decline. But callable bonds have much less potential for capital gains, since it is likely they will be called if interest rates decline.

All bonds have a yield to maturity (YTM) that will differ from the nominal yield if the bond was bought at a premium or discount to face value.

Yield to maturity will depend on how much time remains until maturity, but callable bonds will also have a yield to call (YTC), which is calculated like the yield to maturity, but the call date is substituted for the maturity date and the call price is substituted for face value.

Bonds also have a yield to worst (YTW), equal to the lowest yield of a bond that could occur because of call provisions, prepayments, or other features affecting cash flows.

The yield to call will be higher than the yield to maturity for bonds bought at a discount since the gain from the discount will be received sooner. If the bond was bought at a premium, then the yield to call will equal the yield to worst for most bonds, which will be less than the yield to maturity, since the loss of some of the premium from redemption occurs sooner when the bond is called.

To summarize, for most callable bonds (assuming call price = face value):

• Bought at a discount: YTC > YTW = YTM
• Bought at a premium: YTC = YTW < YTM

Broker listings for bonds show both the yield to worst and the yield to maturity.

Most people buy their agency bonds from brokers, who purchase them in large blocks, then resell them to their customers. Brokers determine the minimum purchases, which, in most cases is $1,000, but some brokers may require a minimum purchase of 5 or 10 securities, resulting in a minimum purchase of $5,000 or $10,000, respectively.