Agency Bonds – Everything You Need to Know

Agency bonds are one of the most popular types of bonds. They offer excellent investments which not only bring income but also diversify your portfolio. Also, bonds are generally less risky in comparison to stocks and with the right approach and strategy, you can get maximum yield from the bonds.

Before you dive in head first, you need to know what you are getting yourself into. Remember, knowledge is power, and you cannot trade through new waters without knowledge of what lies in wait.

What are Agency Bonds?

Agency bonds are simply bonds issued by government agencies and that are usually more liquid than other types of bonds. Agency bonds have high-interest rates in comparison to Treasury bonds, but they are a little less liquid than Treasury bonds. Because of this, they are not ideal for some bond investors.

You already know there are different types of bonds, including Treasury, municipal, savings, and agency bonds. Agency bonds have different categories. These include:

Bonds issued by the Federal Government Agency

These include bonds like the Federal Housing Administration (FHPA), Government Mortgage Association (Ginnie Mae) and the Small Business Administration (SBA). Bonds that are offered by the federal government agencies are usually guaranteed by the Federal Government just like Treasury bonds are.

Bonds by Government Sponsored Enterprise

This includes the Federal national mortgage association the federal farm credit banks, the federal home loan mortgage, the Federal home loan bank, and the funding corporation. The Government Sponsored Enterprises are usually quasi-governmental organizations whose intention is to improve the availability of credit and also to reduce the cost of funding to some sectors in the US economy.

Eventually, the risk of capital loss for investors reduces. The government supervises these bonds, but the Federal government doesn’t manage them. Private agencies own these bonds and set them up to yield a profit.

Features of Agency bonds

• The Federal National Mortgage Association and the Federal Home Loan Mortgage have mortgage-backed securities. Because of this, when mortgage defaults were on the rise during the mortgage crises, these bonds sustained huge losses. Since they cannot raise capital and still meet their obligation, they almost collapsed. When they came to the brink of things, the US mortgage housing and lending system were disrupted. To keep them from falling off the ledge, the Federal Government swooped in and made them a bailout.
• Ginnie Mae also deals with mortgages. However, they are a Federal Government Agency, and they have the backing of the Federal Government whereas the other two agencies mentioned above don’t. As GSEs, they are considered independent entities that run for profit. The fact that they have government backing means investors have more faith in them and therefore offer better terms.
• In 2008 the Federal National Mortgage Association and the Federal Home Loan Mortgage received cash injections when they went into conservatorship.
• As a conservator, the FHFA and the US government impose some rules and controls over the entities.

How do Agency Bonds Work?

We have established there are two types of agency bonds, but they both have the same goal, to finance the policies and activities of the agency. Agency bonds come in varied structures as well as coupon rates. Many agency bonds usually make semi-annual payments and require a minimum investment of $10,000 (with $5,000 increments).

Just like Treasury bonds, the agency bonds consider the market demand when it’s putting up structures regarding size, and the terms of their debt. Some bonds are also callable, and others have fixed coupon rates. Additionally, some have floating coupon rates and others have unusual coupon payment dates. Every agency will offer and auction bonds depending on their routine and needs, but most tend to do it monthly.

Wait, what does a callable bond mean? The point of offering agency bonds is so that the agency can cater to its needs, including policies, and expansion activities. However, as they do this, they want to get the cheapest loan they can find. If for some reason, the interest rate is high, and the agency needs to sell bonds immediately, they can make them callable if they expect the interest rate to drop soon. When this happens, they can sell the bonds and then repurchase them at a lower interest rate. In this process, they will end up saving a lot of money that they would have otherwise spent in the form of coupon payments.

Since agencies don’t have the backing of the Federal Government, they have a higher yield in comparison to Treasury bonds but lower than corporate bonds. The level at which an agency is independent of the government determines the probability of default. For instance, Ginnie Mae bonds are less risky in comparison to Freddie Mac and Fannie Mae, but even then, there is a low chance that the government will let these agencies go down on their watch.

Many, but not all, agency bonds are exempt from state and local taxes. This is a huge plus for residents living in states with high taxes.

When you buy an agency bond at a discount, you will be subject to capital gain taxes when you redeem or sell the bonds. The capital losses or gains are taxed at the same rate as regular stocks.

Capital gain tax is a charge assessed on the positive difference between the original price of an asset and the sale price. Long term capital gains tax is a charge on all profits made from selling an asset that you hold 1+ years. The rates vary from 0% to 20% depending on the tax bracket you are in. On the other hand, short term capital gains apply to assets you hold for less than a year. They are similar to ordinary income.

Agency bond risk

Like with any bond, an agency bond has risk associated with interest rate fluctuations. When you buy bonds only for the interest rate to soar sky-high, the spending power of the bond reduces. With this in mind, you can make more money if you wait for the interest rate to increase and then make your purchase. Usually, this type of risk is common with long-term bonds.

The Structure of an Agency Bond

• Fixed coupon rate agency bond – this type of agency bond pays a fixed coupon rate regularly. It can be annually, semiannually or quarterly
• Floating coupon or variable rate agency bond – this is where the interest rate is adjusted with time. The adjustments are usually tied to reference rates including yields on Treasury bonds according to an already determined formula.
• Zero-coupon agency bond – this is given by an agency so that it can meet its short term financing needs. The bond is usually discounted and is redeemable at par upon maturity.
• Callable agency bonds – the issuer can call the bonds at any time to take advantage of dropped interest rates

Advantage and disadvantage of agency bonds

How you can buy and sell bonds

It is possible to purchase bonds directly from the agency and while it makes sense to do so in some cases, you can also explore the below methods.

Buy bonds through brokerage accounts – you can buy agency bonds through a broker. The purchase process is the same as that of stocks. The fees vary depending on the bond broker you use. Also, you should be ready to navigate through confusing options, though some brokerage platforms have put in some effort to make site navigation a breeze. Most platforms also have education sections where you get to analyze the agency bonds and ensure the agency issuing the bond can pay the resulting coupons.

Buy ETFs and mutual funds – when you buy these, you do not have to make a decision of which agency bonds you should invest in. The mutual fund or the ETF Company will decide that for you. The company will then place each of them into different categories, usually by duration and type.

Strategies to employ when buying agency bonds

If you are looking to purchase bonds for the income that they will provide, then your primary concern should be the interest rates. Check if the rates are increasing or decreasing. If the interest rate increases, then the value of your agency bond will plummet and if the interest rate decreases, then the agency bond value will increase. On the other hand, you might be wary of the risk of reinvestment. Will you earn an attractive return once the bond matures?

Because of these concerns, you should optimize the current bond income from the bond portfolio as you take steps to ensure that the bonds still earn income in future.

• Ladders – this is a strategy where you buy bonds with different maturities. You can have one bond maturing in a year, another in two years, and others in here, four or five years. Whenever a bond matures, you can reinvest it into a longer maturity at the top of the ladder. This bond investment strategy is perfect for those who want to minimize the risk of reinvestment without giving up a lot of return. And the event interest rates increase, you will not lose everything.
• Barbells – this is a strategy where you purchase a short term and long term bonds but stay away from the medium-term bonds. The strategy allows you to capture high yields on the long term bonds while you maintain some access to cash with some of the low-yielding short-term bonds. However, long-term bonds tend to fluctuate a lot due to changes in interest rates.
• Bullets – here, you will purchase bonds that will mature at around the same time. For instance, if you know you have a large cost five years down the line, you can purchase a five-year bond and then a four-year bond the following year if you have extra money. After three years, you can add another two-year bond, and at the end of the five years, you will have all your money available at the same time right when it is needed.

In all of the above cases, the strategy you choose should reflect the needs you anticipate as well as your future expectations of market performance over the years.

Reasons why people invest in Agency bonds

• They offer a stable income – agency bonds vary from other bond types, but what they share with the rest are their predictable returns and the regular coupon payments.
• Diversification – bonds usually perform differently in an investment portfolio in comparison to stocks. The difference is great because long-term portfolio volatility is low.
• Reduced risk – bonds normally offer a high degree of security in comparison to stocks. However, agency bonds have a higher risk in comparison to other types of bonds.

Best Agency Bond Brokers

There are many bond brokers to choose from, but not all are available in the US. Even those available in the US, some aren’t as dedicated to your success as others are. To help you choose the best broker firm, below are reviews of some of the top bond brokers in the US.

Verdict

Agency bonds are a good way to diversify your investment portfolio, but before you jump in, it is good if you learn some basics about them. Also, understanding that the agency issuing the bond plays a role in the coupon payment you receive every year or every six months will help you determine if the agency bond is worth your time or not. Be careful to choose the right bond broker, the last thing you want is a broker who doesn’t understand agency bond markets and rakes in losses.

FAQs