What Is an Agency Bond and How Does It Work?
A security issued by a government-sponsored company or a federal government department other than the US Treasury is known as an agency bond. Some are not completely guaranteed, unlike Treasury and municipal bonds in the United States. Agency debt is another name for an agency bond.
TAKEAWAYS IMPORTANT
Government-sponsored enterprise bonds and federal government agency bonds pay somewhat more interest than US Treasury bonds.
State and local taxes are excluded in most cases, but not all.
They are subject to interest rate risk, just like any other bond.
What is the Function of Agency Bonds?
The majority of agency bonds have a set coupon that is paid every two years. They're available in a number of increments, with a $10,000 minimum commitment for the first iteration and $5,000 for subsequent installments. GNMA securities, on the other hand, are sold in $25,000 increments.
The coupon rates on some agency bonds are set, while the rates on others are variable. Interest rates on floating rate agency bonds are modified on a regular basis in response to changes in a benchmark rate, such as LIBOR.
Agency bonds, like other bonds, are subject to interest rate risk. In other words, a bond investor may purchase bonds only to discover that interest rates have risen. The bond's real spending power is lower than it formerly was. Waiting for a higher interest rate to kick in would have allowed the investor to make more money. This danger is obviously bigger for long-term bond prices.
Bonds issued by agencies come in a variety of shapes and sizes.
Federal government agency bonds and government-sponsored enterprise (GSE) bonds are the two types of agency bonds.
Bonds issued by federal government agencies
The Federal Housing Administration (FHA), the Small Business Administration (SBA), and the Government National Mortgage Association (GNMA) all issue federal government agency bonds (GNMA). Mortgage pass-through securities are frequently used to issue GNMAs.
Federal government agency bonds, like Treasury securities, are guaranteed by the United States government's full faith and credit. While owning an agency bond, an investor will get monthly interest payments. The whole face value of the agency bond is refunded to the bondholder upon maturity.
Because they are less liquid, federal agency bonds pay a somewhat higher interest rate than Treasury bonds. Furthermore, agency bonds may be callable, which implies that the issuing agency may choose to redeem them before the maturity date.
Enterprise Bonds backed by the government
The Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal Farm Credit Banks Funding Corporation, and the Federal Home Loan Bank are examples of GSEs.
These aren't government-run organisations. They are private firms that serve a public purpose and hence may get government backing and be subject to government control.
GSE agency bonds are not backed by the US government to the same extent as Treasury and government agency bonds. As a result, credit risk and default risk exist, and the return given on them is often greater.
Some agencies issue no-coupon discount notes, or "discos," at a discount to par to address short-term financial requirements. Discos have maturities ranging from a day to a year, and if sold before maturity, the agency bond holder may incur a loss.
IMPORTANT: Government-sponsored enterprise bonds are not backed by the US government to the same extent as Treasury and other agency bonds.
Consideration of Taxes
Most, but not all, agency bond interest is tax-free on a local and state level. Agency bonds issued by Farmer Mac, Freddie Mac, and Fannie Mae are fully taxable.
When agency bonds are purchased at a discount, they may be liable to capital gains taxes when sold or redeemed. When selling agency bonds, capital gains or losses are taxed at the same rates as stocks.
Local and state taxes do not apply to agency bonds issued by the Tennessee Valley Authority (TVA), Federal Home Loan Banks, and Federal Farm Credit Banks.
