Agency Bonds – What They are and How They WorkFebruary 2nd, 2012 by David Waring
Agency bonds are bonds issued by government agencies and GSEs (government sponsored entities). Agency bonds are considered a low risk investment, just like treasury bonds. However, unlike treasury bonds where there is only one issuer (the Federal Government), agency bonds originate from different entities.
Two types of agency bonds
The two types of agency bonds are government agency bonds and GSE bonds. Bonds issued by a government agency such as USAID, PEFCO and Small Business Administration (SBA) are directly backed by the full credit and faith of the Federal Government. This in effect places their risk level at par with that of treasury bonds.
Not all agency bonds are issued by government agencies though. GSEs are government chartered private corporations with a mandate to fulfil a matter that is of substantial public interest. Examples of GSEs include Fannie Mae and Freddie Mac.
Bonds issued by GSEs do not have the explicit government guarantee that government agency bonds have. However, the government charter and the vital role that the typical GSE plays in the economy implies that the government is unlikely to allow a GSE to default on its bond payments.
A classic example of federal government intervention was the takeover of Fannie Mae and Freddie Mac in the wake of the 2007 sub-prime mortgage crisis. Because of this implicit guarantee, government agency bonds and GSE bonds attract more or less the same interest yield. The majority of agency bonds are GSE-issued.
Risk versus yield
That said, agency bonds have a higher yield compared to treasuries. This accounts for the two main risks agency bonds face that treasuries do not. First, agency bonds carry a political risk. New laws may be passed that revoke or adversely change the federal government’s guarantee.
Second, agency bonds are not as liquid as treasuries. For instance, if a bond mutual fund wants to buy $500 million worth of treasury bonds, such can be initiated and completed via single bond issue in a matter of minutes or hours. High volumes and values are characteristic of the treasury bond market. On the other hand, purchasing $500 million worth of agency bonds can take weeks and even then, the purchase will have to be broken down into different bond issues, making the entire process inefficient.