Agency Bonds

Agency bonds or agency issues are debt securities issued by either Government Sponsored Enterprises (GSEs) or Federal Government agencies which may issue or guarantee these bonds.

GSEs are usually federally-chartered but privately-owned corporations such as FNMA (Federal National Mortgage Association) and FHLMC (Federal Home Loan Mortgage Corporation).

Government agencies include the Small Business Administration, GNMA (Government National Mortgage Association), and the FHA (Federal Housing Authority). A key difference here is that securities issued by GSEs are not direct obligations of the US Government, while those issued or guaranteed by GNMA (Ginnie Mae), the SBA, and the FHA are guaranteed against default just like T-Bills, T-Notes, and T-Bonds.

Agency securities tend to promote a public purpose. For example, FNMA and FHLMC purchase mortgages from lenders, which encourages lenders to make more loans and increase home ownership. Similarly, the Federal Farm Credit Banks provide assistance to the agricultural sector, while the Small Business Administration pro¬vides assistance to small businesses.

Fannie Mae (FNMA) and Freddie Mac (FHLMC) are public companies with common stock, unlike GNMA. While the US Government has provided financial assistance to these entities, it has not guaranteed their debt securities or preferred stock issues, let alone their common stock. So, while investing in Ginnie Mae involves no credit or default risk, this is not the case with Fannie and Freddie.

A minimum investment of $25,000 is required for GNMA mortgage-backed securities. Investors receive monthly interest and principal payments from a pool of mortgages.

When will the mortgages in the pool be paid off ?
 That is an uncertainty. If interest rates drop, the mortgages will be repaid sooner than expected, which we call prepayment risk. If interest rates go the other way, it will take longer than expected for the homeowners to pay off the mortgages, which we call extension risk. GNMA, FNMA, and FHLMC mortgage-backed securities all carry this risk, which we mentioned earlier.

GNMA is backed by the full faith and credit of the US Government. Still, the yields are typically higher than what one would receive on a Treasury security of a similar term due to prepayment and extension risk.

Interest rates on mortgage securities from FNMA and FHLMC are also higher than on Treasury and higher than corporate bonds to reflect the compensation for the uncertainty of their maturity as well as their higher credit risk. While FNMA and FHLMC buy mortgages and issue mortgage-backed securities, GNMA adds her guaranty to mortgage-backed securities that have already been issued. FNMA and FHLMC do guarantee payment to investors, but, again, neither is the federal government, and both charge fees to provide the guarantee.