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Agency Bond Basics

Bond Instruments

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An Agency bond are issued by government affiliated corporations and government subsections. A “government affiliated corporation” is created by the government to serve specific functions for the public. They may provide mortgages to homeowners, assist small business, or provide loans to citizens. Some of them even publicly issue shares for investor purchases on share exchanges. It’s important to note that these bonds are not treasury bonds. While they share some similarities, they are not the same.

Examples of the dissimilarity are easy to find. An agency bond is fully marketable and can be bought or sold in secondary markets, while certain government issues cannot. These bonds suffer from the downsides which come from secondary issues, such as bond pricing markups. The higher the markup the more interest return, and therefore time reward, is canceled out by the cost of the bond. If you are purchasing an agency bond, use FINRA’s price tracing system to ensure you are not being ripped off by a broker.

Another specific difference between an Agency bond and Government bonds is taxation. Government bonds are not taxed at state and local income levels. Municipal bonds are not taxed at the federal level, and may not be taxed at state and local levels. Most Agency bonds are taxed at all levels, but some may be exempt at state and local levels.

Marketable treasury bonds are extremely liquid, barring changes in interest rates lowering demand for previously issued bonds. An Agency bond is not as liquid since they have less usage by institutional investors. They also have a status known as “Moral Obligation” which limits investor’s willingness to purchase.

This status stems from agency bond’s two possible statuses. The first has “Full Faith and Credit” backing of the government. The government will directly reimburse these bonds, so they cannot default unless the government defaults. These bonds are essentially as safe as government bonds and pay close to the same rate of return. They have higher yields than government bonds, but essentially the same.

The second default scenario operates in the grey area of “Government Sponsored Entities”, or GSEs. The government has a “Moral Obligation” to ensure these Government Sponsored Entities do not default. A “Moral Obligation” does not mean the government would be forced to pay in case of default. They probably will, but are not required, to reimburse bondholders. Since the government does not have to compensate these bondholders they pay slightly higher interest for associated risks, which are fairly close to government bond rates. To make matters more confusing, a “Moral Obligation” status could technically be revoked by the government at any time. It is not guaranteed.

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