Bond Investing For Dummies
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Who or what issues agency bonds? The answer to that question is more complex than you may imagine. This article will help you sort it out.

A few common agencies

Following are just some of the many agencies that issue bonds:

  • Federal Farm Credit Banks (FFCB)

  • Federal Home Loan Banks (FHLB)

  • Federal Home Loan Mortgage Corporation (FHLMC)

  • Federal National Mortgage Association (FNMA)

  • Financial Assistance Corporation (FAC)

  • Financing Corporation (FICO)

  • General Services Administration (GSA)

  • Government National Mortgage Association (GNMA)

  • Government Trust Certificates (GTC)

  • Private Export Funding Corporation (PEFCO)

  • Resolution Funding Corporation (REFCORP)

  • Small Business Administration (SBA)

  • Tennessee Valley Authority (TVA)

  • U.S. Agency for International Development (USAID)

Don’t get lost in this alphabetical muck!

Separating federal agency bonds from GSEs

The first thing to know about these various government agencies is that they fit under two large umbrellas . . . well, maybe three umbrellas at the moment. Some of the agencies that issue bonds really are U.S. federal agencies; they are an actual part of the government just as Congress, the jet engines on Air Force One, and the fancy silverware at the White House are.

Such official agencies include the General Services Administration, the Government National Mortgage Association, and the Small Business Administration. The U.S. Post Office also once issued bonds but has not done so lately.

Most of the so-called agencies, however, aren’t quite parts of the government. They are, technically speaking, government-sponsored enterprises (GSEs): corporations created by Congress to work for the common good but then set out more or less on their own. Many of these faux agencies are publicly held, issuing stock on the major exchanges.

Such pseudo-agencies include the Federal Home Loan Mortgage Corporation (known colloquially as Freddie Mac), the Federal National Mortgage Association (known as Fannie Mae), and the Federal Home Loan Banks. You notice, of course, that these nongovernmental enterprises start with the word “Federal.” Confusing, isn’t it?!

What’s the difference between the two groups, especially with regard to their bonds? The first group (the official-government group) issues bonds that carry the full faith and credit of the U.S. government. The second group, well, their bonds carry that mysterious implicit guarantee or moral obligation.

Because this second group is much larger than the first — both in terms of the number of agencies and the value of the bonds they issue — when investment experts speak of “agency bonds,” they are almost always talking about the bonds of the GSEs.

Now, if matters weren’t complicated enough, you’ll recall the recent appearance of a third umbrella. Ready? After finding themselves in hot water during the subprime mortgage crisis, the two largest of the GSEs — Freddie Mac and Fannie Mae — are currently in receivership.

In other words, they’ve been more or less taken over by the federal government. So for the moment, they are, in effect, more like real federal agencies than they are GSEs.

At least as far as bondholders are concerned, the bonds of these two agencies now — for the time being — no longer carry the implicit government guarantee of your investments. Instead, they now carry an explicit guarantee. The future remains uncertain.

Sizing up the government’s actual commitment

No GSE yet has defaulted on its bonds — either traditional bonds or mortgage-backed securities. The closest we’ve ever seen was the Federal Farm Credit Banks (FFCB) during the 1980s when banks were foreclosing on small farms faster than a swarm of locusts can chew up a crop. No FFCB bonds were defaulted, but nervousness in the markets caused their prices to plunge.

Would the Treasury have stepped in to save the day if the crisis continued? Perhaps, in theory, yes. But because the theory has never really been put to the test, investors got sweaty palms.

Those who sold their FFCB bonds prior to maturity lost a bundle. Of course, those intrepid investors who scooped up the bonds at bargain prices made a mint.

Because of the very small risk of default inherent in agency bonds and the greater risk of price volatility due to public sentiment, and because of lesser liquidity and less certain tax considerations, agency bonds — at least those that are not mortgage-backed — tend to pay slightly higher rates of interest than Treasury bonds. The spread between Treasuries and the agency bonds is extremely small, almost never beyond half a percentage point.

The mortgage-backed securities issued by agencies tend to yield higher returns than other agency bonds — not because of the risk of default but because of their greater volatility given the ups and downs of the mortgage market (particularly of late) to which the interest payments are tied.

About This Article

This article is from the book:

About the book author:

Russell Wild, MBA, an expert on index investing, is a fee-only financial planner and investment advisor and the principal of Global Portfolios. He is the author or coauthor of nearly two dozen nonfiction books.

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