Agency Bonds

Definition

Agency bonds are debt securities issued by government-sponsored enterprises (GSEs) or federal agencies to finance their operations and activities. These bonds are typically backed by the issuing agency's ability to collect revenues or receive government support, making them relatively safe investments. Investors often look to agency bonds for their higher yields compared to Treasury bonds, while still maintaining a low level of risk.

5 Must Know Facts For Your Next Test

1. Agency bonds are generally considered safer than corporate bonds because they are issued by GSEs or federal agencies with government backing.
2. The yield on agency bonds is usually higher than that of Treasury securities due to the slightly increased risk associated with them.
3. Examples of agencies that issue these bonds include Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.
4. While agency bonds have low default risk, they can still be affected by interest rate changes, impacting their market value.
5. Investors often include agency bonds in their portfolios for diversification, as they offer a blend of safety and yield.

Review Questions

• How do agency bonds differ from Treasury securities in terms of risk and yield?
  • Agency bonds typically offer higher yields than Treasury securities because they carry a slightly higher risk. While Treasury securities are backed by the full faith and credit of the U.S. government, agency bonds are issued by government-sponsored enterprises or federal agencies that may not have the same level of backing. This difference in risk profile means that investors can earn better returns on agency bonds, but they also need to consider the potential for price volatility related to interest rate changes.
• Discuss the role of government-sponsored enterprises (GSEs) in the issuance of agency bonds and their impact on the housing market.
  • Government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac play a crucial role in the issuance of agency bonds by providing liquidity and stability in the housing market. These GSEs issue agency bonds to finance mortgage loans, thus supporting homebuyers by making it easier for them to obtain mortgages. The presence of GSE-backed agency bonds helps reduce borrowing costs for consumers while also ensuring that there is a steady flow of capital into the housing sector, which is vital for economic growth.
• Evaluate the impact of interest rate fluctuations on agency bonds and how investors can manage this risk.
  • Interest rate fluctuations significantly affect the market value of agency bonds, as rising rates typically lead to lower bond prices. Investors can manage this interest rate risk through various strategies, such as diversifying their bond portfolios or using bond ladders to spread out maturity dates. Additionally, some investors might consider floating-rate agency bonds, which adjust their coupon payments based on prevailing interest rates, thereby offering some protection against rate increases.

Related terms

Government-Sponsored Enterprises (GSEs): Financial institutions created by Congress to enhance the flow of credit in certain sectors of the economy, such as housing, by providing liquidity and stability.

Mortgage-Backed Securities (MBS): A type of asset-backed security that is secured by a collection of mortgages, often issued or guaranteed by GSEs, making them closely related to agency bonds.

Risk-Return Tradeoff: The principle that potential return rises with an increase in risk; agency bonds present a unique balance between the two, appealing to conservative investors seeking better yields.