Government agency bonds

Government agency bonds are debentures issued by a Federal Agency or a government-sponsored enterprise (GSE). Bonds issued by a Federal Agency are backed by the full faith and credit of the Untied States government. Agency debentures issued by a GSE are backed only by that GSE's ability to pay.

Agency bonds issued by federal government agencies
Federal agencies issuing bonds include:


 * Federal Housing Administration
 * GNMA (Ginnie Mae)
 * Small Business Administration

These bonds are backed by the full faith and credit of the U.S. government to pay interest and pay back principal at maturity. Some agency issues may be callable and subject to call risk. Agency issues are less liquid than treasury bonds and usually pay a slightly higher interest rate as compensation. Tennessee Valley Authority (TVA) bonds are not backed by a government full faith and credit guarantee but rather by the power revenue generated by the Authority.

Other agencies of the Federal Government issue bonds through the Federal Financing Bank (created in 1973 to lower borrowing costs for smaller governmental agencies).

Bonds issued by Government Sponsored Enterprise (GSEs)
GSEs issuing bonds include:


 * Farm Credit Banks
 * Farm Credit System Financial Assistance Corporation
 * Federal Home Loan Banks
 * Federal National Mortgage Association (Fannie Mae)
 * Federal Home Loan Mortgage Corporation (Freddie Mac)
 * Federal Agricultural Mortgage Corporation (Farmer Mac)
 * Student Loan Marketing Association (Sallie Mae)

GSEs are not backed by the full faith and credit of the U.S. government. These bonds are subject to both credit risk and default risk and the yield on these bonds is typically slightly higher than on U.S. Treasury bonds.

On September 6, 2008, both Freddie Mac and Fannie Mae were placed into conservatorship by the Federal Housing Finance Agency (FHFA), essentially confirming the market's longstanding assumption that the GSEs would be backed by the U.S. Government in case of crisis.

Bond structures
Agency and GSEs issue debt securities with different structures. These structures include:


 * Fixed coupon: Most agency debt issues are fixed rate, non-callable bonds. Note that GNMA securities are (full faith and credit) mortgage pass-through securities. Fannie Mae and Freddie Mac also issue mortgage pass through securities (not full faith and credit) in addition to bond issues.
 * Variable or floating coupon rate: These bonds have floating rates that change periodically. The interest rate is linked by formula to a treasury bond or LIBOR index.
 * No coupon: Very short term agency debt is issued at a discount and matures at par value. These securities are similar in atructure to Treasury bills.
 * Callable: Agencies issue callable bonds with what is known as "step up" coupon rates. Callable agency bonds have a preset coupon rate "step up" option that provides for increases in interest rates or the coupon rate as the bonds approach maturity. This feature is designed to minimize the interest rate risk for investors over time. However, step up bonds are often called by issuers during periods of declining interest rates. A called bond returns an investor's principal sooner than expected and usually forces the investor to reinvest principal at a lower rate of interest.
 * Mortgage backed securities: Mortgage-backed securities (MBS) are pools of first mortgages on residential properties. As the underlying loans are paid off by homeowners, the investors in MBS receive payments of interest and principal over time.

Taxation
Most agency bonds are subject to federal income taxation but are exempt from state and local income tax. GSE bonds are subject to federal, state and local income taxation.

Role in a portfolio
These bonds are as safe (when backed by the full faith and credit of the Government) or almost as safe (GSEs) as Treasury bonds, in terms of risk of default. However, they often have additional options embedded within them, which add risk to the purchaser.

In particular, the oft-included GNMAs have significant negative convexity resulting from the underlying mortgageholder's ability to reduce repayments when rates rise or refinance when rates fall. Since these markets are reasonably efficient, bondholders are compensated by some amount for bearing these risks. Caution to be exercised in designing a portfolio, however, since risks may come into play at precisely the wrong time. This is a topic of discussion that many Bogleheads do not agree on. However, most agree that choosing to include bonds with significant optionality in your portfolio is of secondary importance to choosing your overall stock/bond split in a way that reduces risk to a comfortable level.

A reasonable summary of the controversy might be the following conclusion: Inclusion of such bonds by purchasing Total Bond Market or a similar fund is unlikely to hugely affect portfolio performance (see the arguments of Taylor Larimore on the forum), whereas allowing bonds with significant optionality to comprise a much larger portion of the bond component of your portfolio would likely be unwise. Deciding to not include any such bonds in your portfolio can also be a wise choice (see the arguments of Larry Swedroe).