Agency securities

What Are Agency Securities?

Agency securities are debt instruments issued by U.S. government agencies or government-sponsored enterprises (GSEs). As a category of fixed-income securities, they are designed to fund specific public-policy initiatives, primarily in housing, agriculture, and education. While some agency securities are direct obligations of the U.S. government and are backed by its full faith and credit, most are issued by GSEs, which are privately-owned, publicly-chartered corporations. Notable examples of GSEs include the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Home Loan Banks. Another key issuer is the Government National Mortgage Association (Ginnie Mae), which issues mortgage-backed securities explicitly backed by the U.S. government. Agency securities are generally considered to have a low credit risk due to their association with the government.

History and Origin

The origin of many agency securities is rooted in efforts to provide stability and liquidity to specific sectors of the U.S. economy. Government-sponsored enterprises like Fannie Mae and Freddie Mac were created by Congress to establish a secondary market for mortgages, ensuring a steady flow of funds for housing. Fannie Mae was established in 1938 as part of the New Deal, and Freddie Mac was created in 1970 to increase competition in the secondary mortgage market. These entities do not originate mortgages directly; instead, they purchase mortgages from lenders, package them into mortgage-backed securities (MBS), and sell them to investors.

A significant turning point for agency securities, particularly those issued by Fannie Mae and Freddie Mac, occurred during the 2008 financial crisis. As the housing market deteriorated, both Fannie Mae and Freddie Mac faced severe financial distress. On September 6, 2008, the Federal Housing Finance Agency (FHFA) placed both GSEs into conservatorship to prevent their collapse and stabilize the mortgage market.¹², ¹³, ¹⁴ This action underscored the perception of an implicit government guarantee for these entities' obligations, even though there was no explicit backing by the U.S. government at the time. The conservatorship allowed the FHFA, with support from the U.S. Department of the Treasury, to take control of the firms' operations, inject capital, and ensure their continued ability to provide liquidity to the mortgage market.¹¹

Key Takeaways

• Agency securities are debt instruments issued by U.S. government agencies or government-sponsored enterprises (GSEs).
• They are primarily used to finance public policy initiatives, most notably in housing through entities like Fannie Mae and Freddie Mac.
• While some are explicitly backed by the U.S. government (e.g., Ginnie Mae MBS), many GSE-issued agency securities carry an implicit government guarantee, meaning the market widely believes the government would prevent a default.
• Agency securities generally offer higher yields than U.S. Treasury securities due to their slightly higher, though still very low, perceived credit risk.
• The Federal Reserve frequently purchases agency mortgage-backed securities as part of its open market operations to influence monetary policy.

Interpreting Agency Securities

Investors interpret agency securities based on their perceived safety and yield characteristics. Due to their governmental association, they are considered to have very low credit risk, making them attractive to conservative investors seeking stable income. However, it is crucial to differentiate between agency securities that carry the explicit full faith and credit backing of the U.S. government (like those from Ginnie Mae or the Tennessee Valley Authority) and those issued by GSEs (like Fannie Mae and Freddie Mac) that historically rely on an implicit guarantee.

The implicit guarantee for GSEs means that while the U.S. government does not legally promise to repay these securities in case of default, the market generally operates under the assumption that it would intervene to prevent a systemic financial collapse.⁹, ¹⁰ This perception has historically allowed GSEs to borrow at lower interest rates than they otherwise could, providing an advantage in their funding. Investors evaluate agency securities by considering this nuanced backing, as well as the security's maturity, coupon payments, and callability features.

Hypothetical Example

Consider an investor, Sarah, who wants to invest in a low-risk bond to preserve capital while earning a modest return. She is looking at agency securities as an alternative to U.S. Treasury bonds.

Sarah finds an agency bond issued by the Federal Home Loan Banks with a face value of $10,000, a 3% annual coupon payment, and a five-year maturity. This means she would receive $300 in interest ($10,000 * 0.03) annually for five years. At the end of the five years, she would receive her principal of $10,000 back.

If market interest rates were to fall after she buys the bond, her bond's fixed 3% coupon would become more attractive, potentially increasing its market value. Conversely, if interest rates rise, the bond's market value might decrease. However, holding the bond until maturity ensures she receives all her scheduled coupon payments and the full principal amount, assuming the issuer does not default. Given the implicit backing of the U.S. government for Federal Home Loan Bank obligations, the risk of default is considered very low.

Practical Applications

Agency securities play a significant role in various aspects of finance and investing. For individual investors, they can be part of a diversified fixed-income securities portfolio, offering a balance between the lower yields of U.S. Treasury securities and the higher credit risk of corporate bonds. Their relative safety makes them suitable for those with a low-risk tolerance.

At a broader level, agency securities, particularly agency mortgage-backed securities, are critical to the U.S. housing finance system, providing consistent funding for the mortgage market. The Federal Reserve extensively uses agency MBS in its open market operations. During and after the 2008 financial crisis, and again during the COVID-19 pandemic, the Federal Reserve significantly increased its holdings of agency MBS to support market functioning, lower long-term interest rates, and stimulate economic activity.⁶, ⁷, ⁸ These purchases are a key tool in the implementation of monetary policy, impacting housing costs and overall credit conditions.

Limitations and Criticisms

While generally considered safe, agency securities are not without limitations and criticisms. A primary point of contention revolves around the implicit government guarantee, especially for GSEs like Fannie Mae and Freddie Mac. Critics argue that this implicit backing incentivizes excessive risk-taking by the GSEs, as they can borrow at artificially low rates without bearing the full consequences of their actions. This moral hazard was a significant factor in the 2008 financial crisis, leading to the conservatorship of Fannie Mae and Freddie Mac.⁴, ⁵ The debate continues over whether this implicit guarantee should be replaced with a clear, explicit guarantee or if private capital should assume more risk to reduce taxpayer exposure.¹, ², ³

Another limitation concerns their liquidity compared to U.S. Treasury securities. While agency securities are highly liquid, they may not offer the same depth of market as U.S. Treasuries, particularly for very large transactions. Investors might also face reinvestment risk if callable agency bonds are paid off early by the issuer when interest rates decline, forcing investors to reinvest their principal at lower yields.

Agency Securities vs. U.S. Treasury Securities

The primary distinction between agency securities and U.S. Treasury securities lies in the nature of their government backing and, consequently, their perceived risk and yield.

While both are considered low-risk fixed-income securities, U.S. Treasury securities are often seen as the purest form of risk-free investment because they are direct obligations of the U.S. government and are explicitly backed by its full faith and credit. Agency securities, especially those issued by GSEs, are perceived to have a marginal amount of additional risk due to the implicit nature of their government backing, which is reflected in their slightly higher yields compared to comparable Treasury issues.

FAQs

Are all agency securities explicitly backed by the U.S. government?

No. Some agency securities, like those issued by the Government National Mortgage Association (Ginnie Mae), are explicitly backed by the full faith and credit of the U.S. government. However, securities issued by government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac generally have an implicit government guarantee. This means while there's no legal guarantee, the market widely believes the government would intervene to prevent a default due to their systemic importance.

Why do agency securities typically offer higher yields than U.S. Treasury securities?

Agency securities often offer a slightly higher yield than comparable U.S. Treasury securities because they carry a perceived, albeit very small, additional credit risk. Even with an implicit guarantee, the market demands a small premium for the difference in backing compared to the explicit full faith and credit of the U.S. government that backs Treasuries.

How do agency securities contribute to the housing market?

Agency securities, particularly mortgage-backed securities (MBS) issued by Fannie Mae, Freddie Mac, and Ginnie Mae, are fundamental to the housing market. These entities purchase mortgages from lenders, providing those lenders with fresh capital to issue new loans. By pooling these mortgages and selling them as securities to investors, they create a liquid secondary market that helps keep mortgage interest rates stable and affordable for homebuyers.

Can agency securities be callable?

Yes, some agency securities are callable, meaning the issuer has the right to redeem the bond before its stated maturity date. This typically occurs when prevailing interest rates fall, allowing the issuer to refinance their debt at a lower cost. For investors, callable bonds introduce reinvestment risk, as they might have to reinvest their principal at a lower rate if the bond is called.

Are agency securities a good option for diversification?

Agency securities can be a valuable component for diversification within a fixed-income securities portfolio. They offer high credit quality and generally good liquidity, providing a middle ground between the absolute safety of U.S. Treasuries and the higher risk/return potential of corporate bonds. They can help enhance portfolio yield without significantly increasing overall risk.