What Is an Agency Security?
Agency securities refer to two types of bonds: those issued by a U.S. government-sponsored enterprise (GSEs) and those issued by other U.S. federal government agencies. The latter type of bonds is backed by the full faith and credit of the U.S. government, similar to Treasury bonds. The purpose of GSEs is to reduce borrowing costs for specific sectors of the economy, such as mortgages.
Basics
Government-sponsored enterprises or affiliated federal entities issue low-risk debt obligations known as agency securities. These securities, commonly referred to as "agencies," are issued by entities such as the Federal National Mortgage Association (FNMA), Federal Home Loan Bank, Federal Home Loan Mortgage Corporation (FHLMC), and the Student Loan Marketing Association (SLMA).
Explaining Agency Securities
Government-sponsored enterprises emerged to mitigate borrowing expenses for specific economic sectors. Fannie Mae, officially the Federal National Mortgage Association, aims to enhance credit accessibility in the housing sector. Similarly, Farmer Mac, the Federal Agricultural Mortgage Association, assures punctual repayment of principal and interest for agricultural bond investors. The issuance of a GSE loan in the bond format is termed an agency security, facilitating their role in the financial landscape.
Tax Implications and Exemptions of Agency Securities
Certain agency securities enjoy exemption from local and state taxes on interest, though exceptions exist. Farmer Mac, Freddie Mac, and Fannie Mae agency bonds are fully taxable. Capital gains taxes may apply when selling or redeeming agency bonds purchased at a discount, taxed at rates akin to stocks. Notably, Tennessee Valley Authority, Federal Home Loan Banks, and Federal Farm Credit Banks agency bonds are exempt from local and state taxes. Moreover, agency securities issued regularly are not subject to registration with the Securities and Exchange Commission (SEC).
Tax Status of GSEs and Government Agencies
| Legal Name | Common Name | Tax Status |
|---|---|---|
| Federal Agricultural Mortgage Corporation | Farmer Mac | Fully taxable |
| Federal Farm Credit Banks Funding Corporation | Farm Credit | State and local exempt |
| Federal Home Loan Banks | FHL Banks | State and local exempt |
| Federal Home Loan Mortgage Corporation | Freddie Mac | Fully taxable |
| Federal National Mortgage Association | Fannie Mae | Fully taxable |
| Tennessee Valley Authority | TVA | State and local exempt |
Types of Agency Securities
Government agency bonds issued by entities like the Federal Housing Administration (FHA), Small Business Administration (SBA), Tennessee Valley Authority (TVA), and Government National Mortgage Association (GNMA) exhibit varied features. While GNMAs, often structured as mortgage pass-through securities, lack the U.S. government's full faith and credit support, other federal government agency bonds enjoy this backing. Investors anticipate regular interest payments and the total face value at maturity. Federal agency bonds, less liquid than Treasuries, provide a slightly higher interest rate and may be callable, posing redemption risks.
Distinct from government agency bonds, Government-Sponsored Enterprise (GSE) bonds from entities like Fannie Mae, Freddie Mac, Federal Farm Credit Banks Funding Corporation, and the Federal Home Loan Bank carry credit and default risks. Consequently, their yields typically surpass those of Treasury bonds.
Most agency securities offer semi-annual fixed coupons and are available in various increments, with a common minimum investment of $10,000 for the first increment and subsequent $5,000 increments. However, GNMA securities may be acquired in $25,000 increments. Certain agency bonds feature fixed coupons, while others have floating rates tied to benchmarks like the London Interbank Offered Rate (LIBOR). To address short-term financing needs, some agencies issue no-coupon discount notes or "discos" at a discount to par, with maturities ranging from a day to a year, potentially resulting in losses for investors if sold before maturity.
Conclusion
Agency securities encompass diverse bonds issued by government-sponsored enterprises (GSEs) and federal government agencies, with varying structures and tax implications. While the latter benefits from the full faith and credit of the U.S. government, GSEs play a crucial role in reducing borrowing costs for specific sectors. Investors navigate nuances such as callable federal agency bonds and credit risks in GSE bonds. Despite complexities, agency securities remain integral to facilitating credit accessibility and addressing short-term financing needs in the financial market.