 Personal Finance PowerPoint Presentation, Agency Bond. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Agency Bond, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated August 26, 2020. In prior presentations, we've been looking at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is an agency bond? An agency bond is a security issued by a government sponsored enterprise or by a federal government department other than the U.S. United States Treasury. So when we think about bonds in general, we're typically thinking of, in essence, loaning money to an organization, either the government or a corporation. The government bonds often being those that we use as kind of a measuring tool as a benchmark because we have very little default risk there, meaning default that in essence the bond will be repaid because the U.S. government should be good to pay their obligations given the fact that they have the capacity to tax and basically print money when you're talking about the United States government. Bonds usually paying back the principal at the end, and of course we want to earn some format of interest. Now clearly when you talk about types of bonds that are going to have very low default risk with the lower default risk, then the bond issuer could usually issue the bond for less interest. So you're going to get less of a return typically on them. So as you move away and compare to other types of bonds where you have more risk involved with them, then you've got to be comparing the return that you would be receiving. You would have an expected return or interest or a rate of return that would typically be higher but a higher risk of say default for example. So some are not fully guaranteed in the same way that U.S. Treasury and municipal bonds are. So clearly we want to be understanding what are the guarantees related to the bonds or investments we're putting our money into because that will have a factor in terms of what the market is going to determine and appropriate interest rate will be for the issuance of those bonds. In other words, of course, if we can put our money into very secure Treasury bonds that are backed by the United States government versus another bond, which is not, we would typically put our money in the more secure bond and only put our money elsewhere if we were able to get a greater return. That's how the market is basically going to be working. So Treasury and municipal bonds are. So any agency bond is also known as agency debt. How agency bonds work. Most agency bonds pay a semi-annual fixed coupon. So that's kind of a standard kind of payment structure for many types of bonds, meaning we're going to be paying for the bond basically loaning money to the issuer of the bond. They're going to give it back at maturity and give us basically rent on the money, the interest portion of it, the interest payments instead of rent, like you'd see it on an apartment or something like that being paid monthly. It will often be semi-annual every six months, twice a year. So they are sold in a variety of increments generally with a minimum investment level of $10,000 for the first increment and $5,000 for additional increments. GNMA securities however come in $25,000 increments. Some agency bonds have fixed coupon rates while others have floating rates. So when we think about the rate on the bond, we often think of it bonds in general as being basically more fixed income so that they're going to have kind of a fixed rate that we can basically get a return on, which can have its pros and cons to it. But you could have structure bonds in such a way where you have a floating rate rate actually changing with certain conditions that it will be linked to to determine those changes. The interest rates on floating rate agency bonds are periodically adjusted according to the movement of a benchmark rate such as the LIBOR. So like all bonds, agency bonds have interest rate risks. So clearly the bonds as we've seen when we're comparing stocks and the bonds, interest rate risks is one of the risks with a fixed income type of situation because if you're locking in the interest rate, that can be good. But if inflation goes up, if market rates go up, then you're getting less of a return on the bonds. In other words, if you had the money that wasn't locked into the bonds, you might be able to purchase other bonds or other similar securities at a higher rate of return if the interest rates are going up and you had the cash. So that is a bond investor maybe bonds only to find that interest rates rise. The real spending power of the bond is less than it was. So the investor could have made more money by waiting for a higher interest rate to kick in. So that's going to be the interest rate risk, how it kind of works. But clearly when we're thinking about bonds, we're usually putting them in as kind of an overarching plan to our investment portfolio, possibly hedging a bit against the risk related to, say, stocks or equities. And so even if we're subject to some interest rate risk, we're probably not subject to the kind of volatility or fluctuation of the stock market in the event of like a recession, which might be some of the point or the strategy of having the bonds. So naturally, this risk is greater for long term bond prices. So if we locked in the bond for a longer term, where it's more likely that over that longer term, you're going to have some kind of risk that the market rates go up while you're locked in. So types of agency bonds, there are two types of agency bonds, including federal government agency bonds and government sponsored enterprise GSE bonds. Federal government agency bonds, federal government agency bonds are issued by the Federal Housing Administration, the FHA, Small Business Administration, SBA and the Government National Mortgage Association, the GNMA. GNMAs are commonly issued as mortgage pass through securities. Like Treasury securities, federal government agency bonds are backed by the full faith and credit of the U.S. United States government and investor receives regular interest payments while holding this agency bond. At its maturity date, the full face value of the agency bond is returned to the bond holder. Federal agency bonds offer a slightly higher interest rate than Treasury bonds because they are less liquid. So now we're thinking about why would the market differentiate between the two. You have a little bit less liquidity and therefore, again, that would be an inconvenience to the investor if you're comparing the two and therefore you would expect or demand the market would hire return for it. In addition, agency bonds may be callable, which means that the agency that issued them may decide to redeem them before their scheduled maturity date. So the issuer may try to redeem them, which once again takes away a little bit of control on the investor side of things. And therefore you would expect then that would have an impact on the price in relation to other bonds. Government sponsored enterprise bonds, a GSE is issued by entities such as the Federal National Mortgage Association, Fannie Mae, Federal Home Loan Mortgage, Fannie Mac, Federal Farm Credit Banks, Funding Corporations and the Federal Home Loan Bank. These are not government agencies. They are private companies that serve a public purpose and thus may be supported by the government and subject to government oversight. So these are kind of quasi-government oversight kind of agencies have kind of like a private and federal or government kind of component to them in essence. So you would think that that would have different implications within your investing strategies in terms of whether they can default on their debt or not. You know, you think it'd be less likely than maybe that they would let them totally default on their debt than say a corporation, for example. But even large corporations may not be allowed to default on their debts or go bankrupt if they're too big to fail and so on and so on. So GSE agency bonds do not have the same degree of backing by the U.S. government as treasury bonds and government agency bonds. Therefore there is some credit risk and default risk and the yield offered on them is typically higher. So you would think they don't have the same kind of zero default risk that the other government bonds may have and therefore of course you would demand a higher rate of return with regards to the market. And then you can also compare them to other bonds like corporate bonds and so on and look at the default risk in comparison there. To meet short-term financial needs, some agencies issue no coupon discount notes or discos at a discount to par. Lower than the par of out discos have maturities ranging from a day to two years, two year and if sold before maturity may result in a loss for the agency bond investor. Tax considerations, the interest from most but not all agency bonds is exempt from local and state taxes. So Farmer Mac, Freddie Mac and Fannie Mae agency bonds are fully taxable. Agency bonds when bought at a discount may subject investors to capital gains taxes when they are sold or redeemed. That's kind of like the general rule, right? So now if you sell the bond, you don't wait till maturity and get paid back at maturity, but you sell it early on the market, then you might have a gain on that sale and that would be a capital gain kind of situation. Capital gains or losses when selling agency bonds are taxed at the same rates as stocks. So Tennessee Valley Authority, the TVA Federal Home Blowns Bank and Federal Farm Credit Bank, Bank's agency bonds are exempt from local and state taxes.