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The Sweet Spot in Fixed Income: Exploring Agency Bonds

In the world of bonds, there is a big trade-off between safety and yields. With a bond, you are essentially lending an entity money with a promise to be paid back with interest. Riskier debt or bonds with higher default rate potential often come with higher yields. Safer debt pays less. It is as simple as that. So, finding the balance between yield and safety remains a priority for many investors.

But there is one potential way investors can have their cake and eat it too, with some help from Uncle Sam.

Agency bonds—or those sponsored by government agencies or government-sponsored enterprises (GSEs)—provide much of the safety of Treasury bonds with some extra yield potential. This is where investors can grab some extra income without taking on much extra risk. For investors, agency bonds should be a part of your fixed income portfolio.

Government Sponsored

Like it or not, the United States government is a big bureaucracy. Its scope covers a wide range of departments, agencies, and groups. Under that umbrella, the U.S. issues a lot of debt to pay its bills and securitize its various assets. When most of us think of that debt, we think of the Treasury and various Treasury bonds, bills, and notes. However, there is a whole ecosystem of other government debt and agencies that issue bonds for various purposes.

These are government-sponsored enterprises (GSEs) or agencies of the U.S. government. Some examples include the Federal National Mortgage Association (Fannie Mae), the eleven Federal Home Loan Banks, the National Veteran Business Development Corporation, the Federal Home Loan Mortgage Corporation (Freddie Mac), the Tennessee Valley Authority (TVA), and the Federal Farm Credit Bank. However, this is not an exhaustive list and there are others.

GSEs are interesting, as the key word in their name is sponsored

However, they do have the implicit backing of the Feds. So, when things hit the proverbial fan, the government will step in to save the entity and potentially its bonds. This implicit guarantee was put to the test during the Great Recession when the Federal Reserve stepped in to save Freddie Mac and Fannie Mae with loan stops and Troubled Asset Relief Program (TARP) bailout funds.

Higher Yields

This implicit versus explicit difference works out in terms of yields/income potential and credit quality.

Because they aren’t part of the federal government, GSE and agency bonds have some default risk. Bonds issued by the Tennessee Valley Authority are backed by the revenues their projects generate, and bonds issued by Freddie Mac are supported by the cash flows from mortgages. Moreover, there is some prepayment risk when it comes to GSE bonds. Mortgages are allowed to be paid off early, while projects can throw off enough cash flow to retire bonds.

This combination of factors has agency bonds yielding more than comparable Treasury securities. This chart from brokerage Charles Schwab shows that investors can score some considerable yield advantage in agency bonds as they go out on the maturity spectrum. Today, agency bonds are yielding on average close to 5% versus about 4.5% for Treasury bonds.



Source: Charles Schwab

The kicker is that the implicit guarantee provides some credit risk reduction. The vast majority of agency bonds have the same credit rating as U.S. government/Treasury bonds. We’re talking investment-grade at the top two levels, depending on the rating agency. With agency bonds, investors can score higher yields at the same level of credit risk.

Another reason to consider agency bonds? Lower volatility than other sources of investment-grade debt such as corporate bonds. When looking at investment-grade corporate bonds versus agency bonds, the implicit guarantee provides plenty of protection. There is no backing if Walmart or Coca-Cola files for bankruptcy. As such, during recessionary periods or economic slowdowns, agency bonds tend to outperform investment-grade corporates. This is true even during some very specific events.

For example, during the Great Recession—when housing was a huge factor and Fannie/Freddie required bailout cash—mortgage bonds issued by the two groups still managed to provide excess returns of 1.02% over investment-grade corporate bonds according to Western Asset research. 1

Adding in a similar tax profile as U.S. Treasuries, including the potential for no state or local taxes on their interest, and you have a recipe for a wonderful bond type to add to a portfolio.

Making an Agency Bond Play

In a nutshell, agency bonds offer the best of both worlds. On the one hand, you have strong credit quality and the implicit backing of the Federal government and Uncle Sam’s wallet. This provides a strong credit profile. On the other hand, you get a higher yield than regular Treasury bonds. For investors, agency bonds could be one of the best free lunches around.

Getting your hands on them isn’t too hard either. As U.S. government debt, the secondary market for agency bonds is pretty robust. Most good brokerage platforms allow investors to buy agency bonds with minimal spreads and low costs.

A better way could be to buy one of the ETFs associated with the security type. The vast bulk of them strictly focus on mortgage-backed securities and agency bonds, as these are the largest areas of the agency bond market. However, a few have exposure to TVA and other agency bonds. Like most ETFs, these funds provide low-cost exposure and diversification benefits with a single ticker.

Agency Bond ETFs

These ETFs were selected based on their broad exposure to various agency bonds including MBS bonds. They are sorted by their YTD total return, which ranges from -0.7% to 5.4%. They have expenses between 0.04% and 0.66% and assets under management between $695M and $26B. They are currently yielding between 3.2% and 4.3%.

No matter how they choose to get exposure, investors should consider agency bonds for their portfolios. They offer the best of both worlds in terms of benefits. This includes high yields without additional credit risk versus Treasury bonds. All in all, they can offer a perfect complement to an income portfolio.

The Bottom Line

Balancing yield and credit risk could be a breeze with agency bonds. These bonds issued by GSEs offer high credit quality and high income potential. Adding them to a portfolio can instantly boost yield without taking on much more risk.

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Jun 10, 2024