Updated July 14, 2023
Definition of Agency Bond
Agency Bond refers to the fixed income instruments issued by government-sponsored entities (enacted through a legislature of the government) or federal agency, which the government backs.
Bondholders often compare these Bonds with Treasury securities as they offer safe and higher returns with sufficient liquidity. These bonds offer different structures ranging from simple vanilla to complex structures, and investors need to analyze before deciding to make them a part of their portfolio.
Explanation
Agency Bonds issued by organizations, namely, Government National Mortgage Association (popularly known as Ginnie Mae), Federal National Mortgage Association (popularly known as Fannie Mae), and Federal Home Loan Mortgage Association (popularly known as Freddie Mac). However, both federal agencies issued agency bonds that are explicitly backed by the government, making them equivalent to risk-free US Treasury securities, but also by government-sponsored enterprises (GSE), which are enacted through government charter. Agency Bonds are an important component of the US Debt market and contribute a substantial share after US Treasuries, Corporate Bonds, and Mortgage-Backed Securities.
Characteristics of Agency Bond
Some of the common characteristics of an Agency are enumerated below:
- Investors receive a fixed interest rate on Agency Bonds, which issuers typically pay semi-annually.
- The issuer of Agency Bonds typically pays them in a lump sum as a bullet payment at the end of the maturity, and they are generally non-callable.
- The credit quality of Agency Bonds is Investment grade; However, issuers offer a relatively higher relative yield on such Agency Bonds than the yield offered on US Treasuries.
- Interest rate risk is inherent in these bonds, and most agency bonds are tax-exempt, which means that investment in these bonds results in tax savings for the investor.
How Does Agency Bond Work?
An agency Bond usually issues like a normal bond with a minimum investment in most cases starting from $10000 and in denominations of $5000 each after that. The payment of interest coupons on these bonds is usually fixed; however, sometimes, these are floating, with most of them linked to an external benchmark rate such as LIBOR.
Usually, Agency bonds are issued to meet the financing needs of these corporations and federal agencies (short to medium term), and sometimes agency bonds can take the form of a Zero Coupon Bond as well.
Example of Agency Bond
Agency Bond offerings can take different forms, as discussed below in the types of Agency bonds.
In the below example, we are showing a Medium-Term Bond issued by Fannie Mae with a callable feature as shown below:
| Issue Amount | $20,000,000 |
| Issue Date | 1st Jan 2020 |
| Maturity Date | 31st Dec 2024 |
| Coupon Rate | 3 percent |
| Payment Frequency | Semi-Annual |
| Callable | Yes |
| Call ability Feature enables date | 2 years from the Issue date, i.e., 1st Jan 2022 |
| Call Price | 101 percent of the principal, along with Interest amount accrued |
In the above example, the issuer has issued a Medium-term Agency bond with a callable feature that enables them to redeem the Bond if interest rates are favorable after the call redemption is permitted. Due to the call ability feature, the yield offered is higher than a non-callable Agency bond of the same tenor for the investors of these bonds.
Types of Agency Bond
There are various types of Agency Bonds issued by Issuers. These Agency Bonds can segregate based on the time horizon and synthetic features. A few popular ones are below:
- Short Term Notes: The Short Term Note bonds issue with maturity ranging from as low as one day to a maximum maturity of up to one year.
- Medium-Term Notes: Also known as MTNs, they usually issue maturity ranging from one year above to up to ten years in some cases.
- Zero-Coupon Bonds: Zero-Coupon Bonds normally issue at deep discounts, with the principal amount repaid at maturity and no cash interest flow in the form of coupons.
- Callable Bonds: Issuers include callable features in these bonds, enabling them to recall the bonds before maturity at a predetermined price after a certain period has elapsed.
- Fixed Coupon paying Bonds: The most common type of Agency bond carries a fixed coupon rate payable on a semiannual basis with the principal repayment on maturity.
Agency Bond Risk
Like any other interest-sensitive fixed instrument, Agency Bond also suffers from Interest rate risk, which arises because variation in yield leads to the impact on the price of these bonds. Since Bonds yield carries an inverse relationship with prices, as yields on Agency Bonds increase, they carry the risk of a fall in prices of these bonds, leading to losses for its investors.
Advantages
There are many advantages that Agency Bond offers. Some of the noteworthy are enumerated below:
- It provides a high level of liquidity, making it easy for the holders to liquidate the investment in a short time frame and without many bids ask spread.
- This carries a lower level of risk compared to Corporate Bonds.
- It offers a better return than US Treasuries and carries an Investment grade rating scale.
Disadvantages
There are many disadvantages that Agency Bond offers. Here are some notable examples:
- Agency Bonds offer to return lower than Corporate Bonds and carry high-interest rate risk in a rising interest rate scenario.
- Although Agency Bonds carry less risk than Corporate Bonds, these bonds still carry substantial risk compared to US Treasuries, which are risk-free.
Conclusion
Agency Bonds offer a stable return to investors with a medium risk appetite and add diversification to the portfolio of investors comprising stocks and other fixed-income instruments. These bonds suffer from interest rate risk just like other bonds; despite the systemic risk about the general interest rate, these bonds are a good addition to create a diversified portfolio and offer a return above US Treasuries.
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