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. These Bonds are often compared with Treasury securities as they offer safe and higher return with sufficient liquidity to the bondholders. These bonds are offered in different structures ranging from simple vanilla structures to complex structures, and investors need to analyze before deciding to make them a part of their portfolio.
Explanation
Agency Bonds are 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 agency 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, respectively.
Characteristics of Agency Bond
Some of the common characteristics of an Agency are enumerated below:
- Agency Bonds carry a fixed rate of interest which are normally paid on a semi-annual basis.
- Agency Bonds are usually paid in a lump sum at the end of the maturity in the form of a bullet payment and are usually non-callable.
- The credit quality of Agency Bonds is Investment grade; however, the relative yield offered on such Agency Bonds are relatively higher than that offered on US Treasuries.
- Interest rate risk is inherent in these bonds, and most of these agency bonds are tax-exempt, which means that investment in these bonds results in a tax saving for the investor.
How does Agency Bond Work?
An agency Bond is usually issued like a normal bond with a minimum investment in most cases starting from $10000 and in denominations of $5000 each thereafter. The payment of interest coupon on these bonds is usually fixed; however, these can be floating at times, with most of it 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 offering can take different forms, as discussed below in the types of Agency bonds.
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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 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 to them after 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 be segregated based on the time horizon and based on synthetic features. Few popular ones are mentioned below:
- Short Term Notes: These are short term bonds issued with maturity ranging from as low as one day to a maximum maturity up to one year.
- Medium-Term Notes: Also known as MTNs, these bonds are usually issued with maturity ranging from one year above to up to ten years in some cases.
- Zero-Coupon Bonds: These are normally issued at deep discounts with the principal amount repaid at maturity and no cash interest flow in the form of coupons in between.
- Callable Bonds: These are issued with callable features that allow the issuers to recall the bonds before maturity at a predetermined price after the expiry of a certain period.
- Fixed Coupon paying Bonds: The most common type of Agency bonds carries a fixed rate of coupon payable on a semiannual basis with the repayment of principal on maturity.
Agency Bond Risk
Just like any other interest-sensitive fixed instrument, Agency Bond also suffers from Interest rate risk, which arises on account of variation in yield leading 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 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.
- It carries a lower level of risk compared to Corporate Bonds.
- It offers a better return compared to US Treasuries and also carries an Investment grade rating scale.
Disadvantages
There are many disadvantages that Agency Bond offers. Some of the noteworthy are enumerated below:
- Agency Bonds offer to return lower than Corporate Bonds and carry high-interest rate risk in case of a rising interest rate scenario.
- Although Agency Bonds carry less risk compared to Corporate Bonds, these bonds still carry substantial risk compared to US Treasuries which are essentially 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 of stocks and other fixed-income instruments as well. 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 offers a return above US Treasuries.
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