What is an Agency Bond?

In the world of fixed-income securities, agency bonds represent one of the safest investments, and are often compared to Treasury bonds (T-bonds) for their low risk and high liquidity. But unlike Treasury bonds, which are issued only by the Department of the Treasury, agency bonds come from several sources, including not only government agencies, but also certain corporations granted a charter by the government.

In this article we'll look at different types of agency debt, the tax issues involved with each and see the plethora of options available to individual investors looking for unique bond structures.

Agency bonds generally offer a higher return than Treasury securities, along with higher volatility as the market for mortgage-backed securities responds to changes in mortgage rates. If you invest in agency bonds, you receive earnings when the mortgages in the pool are paid off. The minimum investment requirement may be $25,000 or more.

Not all agency bonds are issued by government agencies; indeed, the largest issuers are not agencies per se, but rather government sponsored entities (GSEs). This is an important distinction, as true agencies are explicitly backed by the full faith and credit of the U.S. Government (making their risk of default virtually as low as Treasury bonds), while GSEs are private corporations that hold government charters granted because their activities are deemed important to public policy.

Among other things, these corporations provide home loans, farm loans, student loans and help finance international trade. Because the government places special emphasis on these activities by granting charters in the first place, the market generally believes that the government would not allow charterholding firms to fail - thus providing an implicit guarantee to GSE debt.

Although agency bond traders recognize this distinction between true agencies and GSEs when buying or selling bonds, nevertheless yields for both types of debt tend to be virtually identical.