Agency Bond – Definition, Types and Characteristics

Definition: Agency bonds are debt securities issued by government-sponsored enterprises or federal government departments. They are not backed by the full faith and credit of the federal government, so they depend on the ability of a specific entity to pay interest and repay the principal. These bonds, also called agency debt, have a narrowly defined interest rate range relative to Treasuries of similar maturities. They have lower yields than Treasuries but higher yields than other securities, such as corporate debt.

There are three basic types of agency bonds. Fixed-Coupon Agency Bonds pay a fixed coupon, which can be paid at any time for any purpose, subject to certain restrictions. Floating-Coupon Agency Bonds pay a variable coupon with a yearly increase based on LIBOR, whichever is higher. There is some leeway in setting the initial rate, but there is no getting out of it once it becomes public. Because agency bonds are so widely traded, there is a lot of market noise around them.

Instead of selling bonds, bond investors buy agency warrants. The difference is that the investor holds the agency warrant until it is sold. When you buy an agency warrant, you get a limited right (call it a right of first refusal) to use the underlying asset(s) for a set period. Selling the warrant gives you the right to use the underlying asset(s) until someone else buys them from you. So you have a better chance of getting the asset you want before somebody else does. This is what makes agency bonds so attractive: they give investors the chance to buy lower-risk assets with more upside potential while getting access to the capital markets with less risk.

Types of Agency Bonds

1. Federal Government Agency Bonds

Federal Housing Administration (FHA), Small Business Administration (SBA), and the Government National Mortgage Association (GNMA) are responsible for issuing Federal government agency bonds.

Federal agency bonds are debts that a government agency has issued to a private person. They carry interest at the prescribed rate and balance due when purchased. Unlike Treasury securities purchased by banks and Wall Street investors, federal agency bonds are issued directly by the U.S. government. Therefore, investors have a direct interest in how the government handles policy. 

The use of bonds as collateral for loan commitments allows lenders to guarantee loan payment by pledging collateral held by the lender as security for the loan. Market makers and investors use federal agency bond prices as benchmarks to make investment decisions.

2. Government-Sponsored Enterprise Bonds

Government-sponsored enterprise bonds provide investors with debt obligations backed by the assets of participating companies. These kinds of bonds are issued by the United States, its agencies, departments, institutions, and private-sector organizations and banks. They are generally secured by the issuer’s real estate, industrial equipment, warehouse facilities, factories, factories, inventory, machinery, natural resources, patents, and other intangible assets (such as software). In a sentence, government-sponsored enterprises are private companies that offer financial securities under the federal government’s endorsement.

As government-sponsored entities, GSE bonds do not have the same standard of backing by the U.S. Government as Treasury and Government Agency Bonds. Therefore, there is credit risk and default risk involved with their investments, and therefore requires a much higher interest rate than Treasury and Government Agency Bonds.

Tax Considerations

Agency bonds are debt issued by government-sponsored agencies, such as Freddie Mac and Fannie Mae. While agency bonds are exempted from many state and local taxes, they are subject to federal taxes.

Several factors can contribute to the amount of capital gains tax you pay on government agency bonds. For example, if you sell an agency bond at a profit before it has matured and you hold it for one year or less, your profit will be subject to ordinary income tax rates and federal and state income taxes. If you hold it over one year, your profit will be subject to capital gains taxes, subject to federal and state income taxes.

The Tennessee Valley Authority (TVA), Federal Home Loan Banks, and Federal Farm Credit Banks are tax-exempt bond issuers. The interest earned on these bonds is not subject to state or local income taxes.

Characteristics of Agency Bonds

Below are the characteristics of Agency Bonds-

1. Low Risk

Unlike other bonds, agency bonds are considered very safe and typically have high credit ratings.

2. Higher return

Agency bonds are a type of debt security that functions as a loan to the Federal government. They have a higher risk and a higher return than treasury bonds, which investors prefer when they have a short-term, high-interest rate strategy.

3. Highly liquid

They are highly liquid, meaning they can be traded very quickly.

Advantages and Disadvantages of Agency Bonds

Advantages

1. Low risk and higher returns

Agency debt is considered low-risk debt compared to corporate debt. The government backs it, so investors get it at a discount. That means they earn a higher return relative to treasuries. And, simply put, this debt comes with a guarantee from the U.S. government.

2. High liquidity

Agency debt is a type of instrument issued by government agencies. This debt is actively traded on public markets and can be bought or sold without a high transaction cost.

Disadvantages 

1. Inflation risk and costs

Buying agency bonds can be a beneficial way to construct a diversified portfolio for many investors. However, you should be aware that returns are reduced in a high inflation environment or too high transaction costs.

2. Interest rate risk

Agency debt will likely fluctuate with the interest rate change.

3. Complexity

  • Agency debt is issued in various forms and can be issued with varying levels of protection and complexity.
  • Because of the various structures of agency securities, it can be difficult to decide if agency debt is suitable for one’s portfolio.