What it means
In everyday language, a federal agency is any department or body of the national government, such as the Treasury or the Small Business Administration. In the bond market, "agencies" means two groups.
One group is true government agencies, whose debt is backed by the full faith and credit of the government, and the other is government-sponsored enterprises, which are privately owned bodies created by Congress to support lending in a particular sector. The difference in backing matters for how risky the bonds are.
Securities guaranteed directly by a government agency are treated as having almost no credit risk, whereas securities of government-sponsored enterprises carry an implied rather than an explicit guarantee. Investors therefore usually demand a small extra yield over a Treasury of the same maturity.
Agency securities are popular with banks, pension funds, insurers and corporate treasurers. They offer a bit more income than Treasuries with high credit quality and active trading.
Many treasury teams use them to hold surplus cash that is not needed for a few months. Agency debt comes in several forms, including fixed-rate bonds, floating-rate notes, callable bonds that the issuer can repay early, and mortgage-backed securities.
Callable bonds pay a higher yield because the investor may be repaid early when rates fall. Each variant should be checked for call dates and any tax treatment before it is bought.
The main nuance is that "federal" in the name does not mean "guaranteed". A finance professional should read the offering documents to see who stands behind the security.
The label alone says very little about the strength of the promise.
In practice
Real-world examples.
Example
A community bank has $20,000,000 of surplus deposits and wants safe assets with better income than Treasuries. It buys agency bonds, which provide a modest extra yield and are easy to sell if the bank needs cash. The treasurer records the securities as available for sale and tracks the spread each month. Each quarter she reports to the board how much of the bank's income comes from this portfolio and how much the market value moved.
Example
A university endowment places part of its short-term reserves in a ladder of agency notes that mature every 6 months. This gives the investment office a predictable stream of cash for payroll and building costs. It also avoids the risk of having to sell a long-term bond at a loss.
Example
A small manufacturer pays a supplier in 90 days and holds $300,000 for that purpose. Its bank puts the money into a short-term agency discount note that matures the day before the payment. The company earns a little interest, and the finance manager is comfortable with the very high credit quality. He also checks that the note cannot be called before the payment date, so the cash is certain to be there.
Formula
Calculation
Yield spread = agency bond yield - Treasury yield of the same maturity
Extra annual income = amount invested x yield spread
Suppose a company has $500,000 of spare cash for 3 years. A 3-year agency bond yields 4.40% and a 3-year Treasury yields 4.00%. The spread = 4.40% - 4.00% = 0.40%, which is 40 basis points (hundredths of a percentage point). Extra annual income = 500,000 x 0.0040 = $2,000, so over 3 years the extra interest is 3 x 2,000 = $6,000, in return for slightly higher credit and liquidity risk.Case study
Seen in the real world.
Meadowbrook Credit Union is an illustrative, fictional lender that holds $60,000,000 in investments to meet liquidity rules. Its treasury committee debates replacing a portion of its Treasury holdings with agency bonds to improve income.
The finance officer calculates that moving $20,000,000 into agency bonds that pay 0.35% more than Treasuries would add 20,000,000 x 0.0035 = $70,000 a year. She then reviews the risks, including the implied guarantee on some issuers, the reduced trading depth in stressed markets, and call features on two of the bonds.
The committee approves a purchase of $12,000,000 in non-callable agency bonds, lifting income by about $42,000 a year in this illustrative case. The lesson is that the extra yield is a payment for specific risks, which should be written down and approved, not treated as free income. The committee also schedules a yearly review so that the holdings are checked against the policy limits.
Watch out
Common mistakes.
- Assuming all agency securities carry the same full government guarantee as Treasuries.
- Ignoring call features, which can force the investor to reinvest at lower rates when the bond is repaid early.
- Comparing yields without matching maturities, which makes the apparent extra income meaningless.
Questions
People also ask.
Are federal agency bonds safe?
They are generally viewed as high quality, but the level of backing differs between issuers, so the offering documents should be checked.
How are agency bonds different from Treasuries?
Treasuries are issued by the government itself with an explicit guarantee, while agencies are issued by agencies or government-sponsored enterprises and often yield slightly more.
Who buys them?
Banks, pension funds, insurers, money market funds, corporate treasurers and individual investors all hold agency debt.
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