Agency Bonds

Agency bond is an umbrella term that refers to a group of different types of securities.

One example is Ginnie Mae, formerly the Government National Mortgage Association (GNMA), which is a corporation run through a division of the federal government called the Department of Housing and Urban Development (HUD). Ginnie Mae does not issue its own securities, but rather guarantees the mortgage-backed securities issued by the Federal Housing Administration or the Department of Veteran Affairs (VA). Though Ginnie Mae is free from credit risk, it is still subject to interest rate risk and what is known as prepayment risk, or the risk that homeowners will pay off their mortgages early, leaving you without the income stream you expect to receive. The only mortgage-backed securities that are guaranteed by the U.S. government, Ginnie Maes usually pay higher rates than Treasuries to compensate for their additional risks.

Unlike Ginnie Mae, government-sponsored enterprises (GSEs) issue a variety of agency bonds that are not guaranteed by the U.S. government, but by the GSEs themselves. Yet, while not technically free of credit risk, investors tend to think of them that way as it is generally assumed the U.S. Treasury will bail out any failing GSE.

GSEs are organized and run like corporations, and some are publicly traded. Farmer Mac, which stands for the Federal Agricultural Mortgage Corporation, is publicly owned and traded on the New York Stock Exchange. The Federal Home Loan Bank, on the other hand, is also a GSE, but is not publicly traded.

Fannie Mae and Freddie Mac are stockholder-owned GSEs that specialize in mortgage-backed securities. Fannie Mae, formerly the Federal National Mortgage Association (FNMA), and Freddie Mac, formerly the Federal Home Loan Mortgage Corporation (FHLMC), were both created by Congress to help subsidize the housing market. Unlike Ginnie Mae, Fannie and Freddie purchase mortgages and then create their own securities, which they sell to the public. Like Ginnie Mae issues, Fannie and Freddie bonds are subject to prepayment risk because they are mortgage-backed securities.

Agency issues come in many forms. Agency bonds pay regular fixed-interest payments until maturity and have terms of two or more years. Discount notes and zero-coupon bonds are like T-bills in that they are sold at a discount and do not pay interest during the term. The difference between the discount you pay and the face value you receive at maturity is equal to your interest. Discount notes have maturities of less than one year. Interest-only bonds are created when securities firms split mortgage-backed agency bonds into tranches that pay the interest portions of mortgage payments. Principal-only bonds are created in the same way that interest-only bonds are created. However, these bonds repay principal but do not pay interest and are sold at a discount like discount notes and zero coupon bonds.