What it is:
Agency bonds are bonds issued by agencies of the U.S. government.
How it works (Example):
Two types of entities issue agency bonds: government corporations, which are entities owned or controlled by the federal government, and government-sponsored enterprises (GSEs), which are chartered by Congress but owned by investors (in fact, shares of many GSEs trade on the New York Stock Exchange). The classification may vary, but the reasons behind the bond issues are the same: to finance the agency's specific activities or policies.
Agency bonds come in a wide variety of structures, maturities, and coupons rates. Most make semiannual interest payments. Many require $10,000 minimum investments (with $5,000 increments thereafter), although GNMA securities come in $25,000 increments. Like the U.S. Treasury, agencies consider the demands of the market when structuring the size and terms of their debt issues. Thus some agency bonds are callable, some have fixed coupon rates, some have floating coupon rates, and some have unusual interest payment dates. Each agency auctions bonds according to its own needs and routine, but many agencies issue bonds monthly.
Unlike Treasuries, agency bonds are not backed by the full faith and credit of the U.S. government. As a result, the yields on agency bonds are typically higher than on Treasuries but lower than corporate bonds. The degree to which an agency is independent from the government affects the default risk associated with its securities. For example, Ginnie Mae is a corporation owned by the government and operated by the Department of Housing and Urban Development; its securities are therefore considered less risky than similar ones offered by Fannie Mae or Freddie Mac. However, the likelihood that the federal government would allow these entities to go bankrupt is considered quite low, and so both Fannie Mae and Freddie Mac securities are generally considered safe. Moody's and S&P rate many agency bonds.
Most, but not all, agency bonds are exempt from local and state taxes. This is especially beneficial to residents of states with high local taxes.
Income investors can purchase agency bonds from a broker/dealer or through mutual funds that target these securities. Mutual funds are usually more appropriate for smaller investments, as diversification is much more expensive when the investor wants to hold the bonds outright.
Why it Matters:
In general, agency bonds are not good investments for those seeking capital appreciation, but they do offer income investors a unique combination of high credit quality, liquidity, and reliable income. Like all bonds, they are sensitive to changes in interest rates. When aleverages increase, agency bond prices fall, and vice versa. The low returns on agency bonds, relative to corporate bonds, also means their investors are more affected by inflation. This inflation risk is somewhat mitigated in cases where the agency bonds have floating-rate coupons, but these "floaters" often have caps or collars that limit how high or how low the coupon rate can go. Changes in the independence or regulation of the issuing agencies can also have dramatic effects on the prices of their bonds.
In general, the agency-bond market is very liquid (though not as much as Treasuries). However, the more "structured" an agency bond is (that is, the more unusual its features), the smaller the market tends to be for the bond. Obviously, this can create liquidity problems for the investor.
It is important to note that agency bonds are a key component of a GSE's ability to provide its intended public service. Usually this public service is to lower the cost of capital for certain groups of citizens by issuing, purchasing, and/or guaranteeing debt. For example, Freddie Mac buys mortgages from financial institutions and then sells unit shares in these pools of mortgages. It does this not only to earn income, but to facilitate homeownership by supplying banks with cash to provide more mortgages. Freddie Mac's purchases of mortgages puts cash back in the hands of lenders, who in turn make more mortgage loans. This increases the supply of funds for mortgages, makes the mortgage industry more competitive, lowers mortgage rates, and thus gives Americans more affordable opportunities to become homeowners.