Government-Sponsored Enterprise Debt Securities
(and Agency Bonds)
Traditionally considered high-quality, income-generating vehicles, government-sponsored enterprise securities typically offer relative safety, predictable income and competitive returns over Treasuries. Government-sponsored enterprises (GSEs) were established by acts of Congress to support various public policies, such as homeownership, farming, education, and natural resource development by ensuring liquidity in the secondary market. GSEs do not lend directly to the public but purchase loans in the secondary market. Although GSEs carry the implicit backing of the U.S. government, they are not direct obligations of the government. This means that payments of interest and principal are the obligation of the issuers. One exception exists, however. In 1968, Congress created the Government National Mortgage Association, or Ginnie Mae, and debt securities issued by Ginnie Mae are backed by the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac are presently under the Federal Housing Finance Agency’s conservatorship. During the conservatorship, both enterprises will continue normal business operations, including interest and principal payments. For more information, please visit fhfa.gov.
In order to support public policies, GSEs purchase new mortgages and other loans from issuers, who then use the proceeds to issue new loans. The GSEs issue notes, bonds and mortgage-backed securities via periodic auctions as well as through various securities dealers. The amount of debt issued and the frequency of issuance depend on each GSE’s need for funding. The most active participants are shown in the following table.
| GSE | Securities Issued | Borrow from the Treasury | State and Local Tax Exempt | Government Guarantee |
|---|---|---|---|---|
| Federal Home Loan Bank (FHLB) | Notes, bonds, discount notes | Yes | Yes | No |
| Federal Home Loan Mortgage Corporation (Freddie Mac) | Notes, bonds, discount notes, MBS | Yes | No | No2 |
| Federal National Mortgage Association (Fannie Mae) | Notes, bonds, discount notes, MBS | Yes | No | No2 |
| Federal Farm Credit Bank (FFCB) | Notes, bonds, discount notes | Yes | Yes | No |
| Tennessee Valley Authority (TVA)* | Notes, bonds | Yes | Yes3 | No |
| MBS | Yes1 | No3 | Yes | |
| Financial Corporation (FICO) | Bonds | No | Yes3 | No |
| Resolution Funding Corporation
(REFCORP) |
Bonds | Yes | Yes | Yes/No4 |
*Issuer is a government agency
1Ginnie Mae is financed through the U.S. Treasury.
2Freddie Mac and Fannie Mae are currently under FHFA conservatorship; see details in the “Credit Quality” section.
3Some exceptions apply.
4Interest payments are guaranteed by the U.S. government; principal is collateralized by U.S. Treasury zero-coupon bonds.
Features and Benefits of GSE Securities
GSE securities are offered in a wide range of maturities and may incorporate a variety of features to meet investor demand. The most common feature is a call, which entitles an issuer, at its option, to pay back the principal before the stated maturity date. Generally, the issuer may call bonds when interest rates decline. New securities may then be offered with lower coupon rates to reduce the issuer’s cost of capital. Callable bonds generally offer higher rates than non-callable alternatives in order to compensate investors for giving the issuer an option to redeem the bonds early.
Predictable Income
GSE securities offer predictable interest payments for investors looking to supplement periodic income. Interest payments are made monthly, quarterly, semi-annually or at maturity.
Although many GSEs issue notes and bonds with fixed coupon rates, some offer securities with variable interest rates such as floating rate coupons and step-up coupons. Based on individual investment objectives, variable-rate bonds may help investors meet future financial needs and create a defensive strategy against a potential rise of interest rates and/or inflation.
Competitive Returns
For investors concerned with the safety of invested principal but looking for higher return, GSEs generally offer competitive yields over Treasuries and may offer comparable yields to other guaranteed securities, such as CDs.
Credit Quality
GSE debt carries the implicit backing of the U.S. government but is not a direct obligation of the U.S. government. Currently, senior debt of GSEs is rated “AAA/AA+,” while subordinated debt of Fannie Mae and Freddie Mac is currently rated AA2/AA-. A credit rating of a security is not a recommendation to buy, sell, or hold securities and may be subject to review, revisions, suspension, reduction or withdrawal at any time by the assigning rating agency. Please contact your financial advisor for current rating information.
Fannie Mae and Freddie Mac are presently under the Federal Housing Finance Agency’s conservatorship. Previous deterioration of the housing market tested the safety and soundness of these two enterprises, compromising their ability to provide stability and liquidity to the mortgage market. In order to restore investors’ faith and help raise additional capital, the FHFA took control of Fannie Mae and Freddie Mac’s operations. During the conservatorship, both enterprises will continue their normal operations, including interest and principal payments. For more information, please visit fhfa.gov.
Taxation
Interest income and capital gains/losses from most GSE securities are subject to federal income tax. Interest income paid by several GSEs is exempt from state and local taxes: FHLB, FFCB, TVA, FICO, and REFCORP. FNMA, FHLMC, and GNMA are subject to state and local taxes. Investors should consult with a tax professional to ensure proper tax reporting.
Diversification
GSEs can offer securities with competitive yields and lower risks. A wide range of maturities, payment frequencies, coupon structures, and other features can potentially help investors realize individual financial objectives and stabilize portfolio returns.
Diversification does not ensure a profit or protect against a loss.
Liquidity
Although not obligated to do so, many broker/dealers participate in the secondary market for agency securities. Investors who need access to cash may sell their bonds prior to maturity, at current market prices. In the secondary market, trading timeliness and prices are subject to market interest rates, issue and position size, credit rating, and other factors. Some bonds trade more often than others and may be easier to sell. The proceeds from sale may be more or less than the original investment. However, barring default, if bonds are held until the final maturity date, the investor should receive the bond’s full face value.
In order to improve market transparency, the Financial Industry Regulatory Authority (FINRA) created TRACE – Trade Reporting and Compliance Engine. Investors can access historical data on market transactions for publicly traded securities, including agency and corporate bonds, at investinginbonds.com.
Investment Considerations
As GSE securities evolve and become more complex, investors should have a clear understanding of risks and benefits before investing.
Market prices of fixed income securities may be affected by several risks, which include but are not limited to: interest rate risk - a rise (fall) in interest rates may reduce (increase) the market value, default or credit risk - the issuer’s ability to make interest and principal payments, and liquidity risk - the ability to buy (or sell) bonds in an efficient manner at a fair market price.
For a detailed explanation of GSE securities-specific risks and those of fixed income in general, please read What you need to know about the risks of bond investing and Factors That Affect Prices of Fixed Income Securities.
Interest Rate Risk
Prices of GSE securities fluctuate just as with any fixed income securities. As interest rates fall, the prices of GSEs will rise and conversely when interest rates rise, the price of GSEs will fall. The prices of longer-term fixed income securities are typically more sensitive to changes in interest rates.
Reinvestment Risk
Reinvestment risk is generally the result of declining market interest rates. Callable bonds are more likely to be called when interest rates drop low enough that reissuance saves the issuer interest expense. Holders of a called bond are faced with reinvesting funds in a lower interest rate market.
If you wish to learn more about government-sponsored enterprises and their debt securities, please ask your financial advisor for FINRA’s GSE Debt Securities brochure or visit investinginbonds.com.