Compare and Contrast Agency Bonds - dummies

By Russell Wild

All agency bonds are considered high quality with very little risk of default, but they aren’t all created exactly equal. Here, sort through some considerations to keep in mind when researching agency bonds for your portfolio.

Eye default risks, yields, markups, and more

The honest-and-true federal agencies, such as the Small Business Administration (SBA), are said to have no risk of default; therefore, their bonds pay more or less what Treasuries do. You may get a smidgen more interest (maybe 5 basis points, or 5/100 of 1 percent) to compensate you for the lesser liquidity of such agency bonds (the lesser ability to sell them in a flash).

Other agency bonds are issued by government-sponsored enterprises (GSEs), and the risk of default, although real, is probably next to nothing. You get a higher rate of interest on these bonds than you do with Treasuries to compensate you for the fact that the risk of default does exist.

With all agency bonds, you pay a markup when you buy and sell, which you don’t with Treasuries if you buy them directly from the government. If you’re not careful, that markup could easily eat up your first several months of earnings. It also could make the difference between agency bonds and Treasury bonds a wash.

Most agency bonds pay a fixed rate of interest twice a year. About 25 percent of them are callable, meaning that the agencies issuing the bonds have the right to cancel the bond and give you back your principal.

The other 75 percent are non-callable bonds (sometimes referred to as bullet bonds). Callable bonds tend to pay somewhat higher rates of interest, but your investment takes on a certain degree of uncertainty.

Investing in individual agency bonds, or individual bonds of any kind, for that matter, is not an activity for poor people. Although you may be able to get into the game for as little as $1,000, bond brokers typically mark up such small transactions to the point that they simply don’t make sense.

It wouldn’t be a good idea even looking at individual agency bonds unless you’ve got at least $50,000 to invest in a pop. Otherwise, you should be looking at bond funds or at individual Treasuries that you can buy without paying any markup whatsoever.

When choosing among different agencies, you want to carefully compare yields-to-maturity and make sure that you know full well whether you are buying a traditional bond or a mortgage-backed security. They are totally different animals.

Weigh taxation matters

The taxes you pay on agency bonds vary. Interest from bonds issued by Freddie Mac and Fannie Mae is fully taxable. The interest on most other agency bonds — including the king of agency bonds, the Federal Home Loan Banks — is exempt from state and local tax.

Treasury bonds, which most resemble agency bonds, are always exempt from state and local tax. Municipal bonds are almost always free from federal tax. Needless to say, your personal tax bracket will make some bonds look better than others.

Discos, floaters, and step-ups

Some agencies, in addition to issuing traditional bonds that pay semiannual interest, also issue no-coupon discount notes, known among bond traders as discos. Discos are similar to Treasury bills.

They usually carry short-term maturities (up to one year), sell at a discount, and pay all interest along with principal at maturity. They are used more by institutions than by individuals, which is probably a good thing: Most individuals who buy bonds tend to enjoy the more regular income.

Another type of agency bond is called a floater. The coupon rate of a floater is based on some benchmark, such as the three-month T-bill (Treasury bill) rate, and can change from month to month. These are complicated beasts, and I suggest steering clear. Fixed-income investments should be fixed.

Not quite as unpredictable as the floater, yet another kind of agency bond is known as a step-up. With a step-up, you get a coupon rate that “steps up” according to a pre-set calendar. As time rolls on, you may collect more interest.

Step-ups can be good investments in that they shield you from having to eat crow with a low-interest investment when interest rates are on the rise. The problem with them is that they are typically callable, which means the agency can toss your principal back to you at any time, and you’re left holding cold cash with perhaps nowhere to go.