Agency Bond

Agency Bond: Definition, Types, How They Work, and Tax Rules

Key takeaways
* Agency bonds are debt securities issued by federal government agencies or government‑sponsored enterprises (GSEs).
* They generally pay slightly higher yields than U.S. Treasuries but can carry varying degrees of government backing and credit risk.
* Most agency bond interest is exempt from state and local taxes, but tax treatment varies by issuer.
* Main risks: interest‑rate risk, call risk, and (for GSEs) some credit/default risk.

What is an agency bond?
An agency bond (or agency debt) is a bond issued by a federal government agency or a government‑sponsored enterprise rather than by the U.S. Treasury. Some agency bonds are backed by the full faith and credit of the U.S. government; others are issued by privately chartered GSEs that have government ties but not the same explicit guarantee.

How agency bonds work
* Coupon and payment: Most agency bonds pay a fixed semiannual coupon; some have floating rates adjusted to a benchmark (historically LIBOR or similar).
* Denominations: Typical minimums start at $10,000 for the first increment and $5,000 for additional increments; GNMA securities commonly come in $25,000 increments.
* Callable features: Some agency bonds are callable, allowing the issuer to redeem them before maturity.
* Discount notes: To meet short‑term needs, some agencies issue no‑coupon discount notes (“discos”) with maturities from one day up to a year.

Types of agency bonds
1. Federal government agency bonds
* Issued by agencies such as the Federal Housing Administration (FHA), Small Business Administration (SBA), and Government National Mortgage Association (GNMA).
* Often backed by the full faith and credit of the U.S. government (GNMA pass‑through securities are an example).
* Typically offer slightly higher yields than Treasuries because of lower liquidity and, in some cases, callable features.

1. Government‑sponsored enterprise (GSE) bonds
2. Issued by entities like Fannie Mae, Freddie Mac, Federal Farm Credit Banks, Federal Home Loan Banks, and similar institutions.
3. GSEs are privately chartered but serve public purposes and are subject to government oversight; they do not carry the same explicit government guarantee as Treasury securities.
4. Tend to offer higher yields than government agency bonds to compensate for credit/default risk.

Tax considerations
* State and local taxes: Interest from most agency bonds is exempt from state and local taxes, but there are exceptions. For example, Fannie Mae, Freddie Mac, and Farmer Mac interest is generally fully taxable at the state and local level.
* Specific exemptions: Bonds from the Tennessee Valley Authority (TVA), Federal Home Loan Banks, and Federal Farm Credit Banks are typically exempt from state and local taxes.
* Capital gains: If an agency bond is purchased at a discount and later sold or redeemed, the investor may realize taxable capital gains or losses, taxed similarly to stock capital gains.

How to buy agency bonds
* Agency bonds are available through broker‑dealers and major brokerage platforms; they are listed in bond screeners alongside Treasuries, municipal bonds, and corporate bonds.
* Minimum purchase sizes and available issues will vary by broker.

Risks
* Interest‑rate risk: Prices fall when market interest rates rise; longer maturities are generally more sensitive.
* Call risk: Callable agency bonds may be redeemed early, limiting upside if rates decline.
* Credit/default risk: Federal agency bonds backed by the U.S. government carry minimal credit risk; GSE bonds have more credit risk and typically higher yields to compensate.

Bottom line
Agency bonds occupy a middle ground between U.S. Treasuries and corporate bonds. They are widely used by investors seeking relatively safe, income‑generating securities with yields slightly above Treasuries. However, differences in government backing, liquidity, tax treatment, and call provisions mean investors should evaluate each issuer and issue individually before investing.