What Is a Government Sponsored Enterprise Bond?
A government sponsored enterprise bond is a debt instrument issued by a government-sponsored enterprise (GSE), which is a privately-owned financial services entity created by the U.S. Congress to enhance the flow of credit to specific sectors of the economy. These bonds, classified under fixed income securities within the broader debt instruments category, are issued to raise capital for the GSE's operations, primarily in the housing, agricultural, and education finance markets. While not direct obligations of the U.S. government, they often carry an implicit guarantee or perceived backing due to their federal charters and critical public policy roles. This perceived backing generally leads to lower credit risk and higher liquidity compared to corporate bonds, making them attractive to a wide range of investors.
History and Origin
Government-sponsored enterprises, such as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), were established to create secondary market liquidity for mortgages. Fannie Mae was chartered in 1938 as part of the New Deal, initially as a government agency to expand the mortgage market. Freddie Mac was created in 1970 to provide competition and further enhance liquidity in the housing finance system. Both entities operate under congressional charters to fulfill their mission of providing stability and affordability to the mortgage market by purchasing mortgages from lenders and packaging them into mortgage-backed security (MBS) products.15, 16
The implicit government backing of these entities and their bonds became a prominent issue during the 2008 financial crisis. As the housing market deteriorated and defaults on subprime mortgages surged, Fannie Mae and Freddie Mac faced severe financial distress.13, 14 To prevent a complete collapse that would have posed significant systemic risk to the broader financial system, the Federal Housing Finance Agency (FHFA) placed both Fannie Mae and Freddie Mac into conservatorship in September 2008.11, 12 This intervention was one of the largest government interventions in the housing market, involving substantial financial support from the U.S. Department of the Treasury.9, 10 This conservatorship underscored the market's long-held assumption of an implicit government guarantee for these entities' obligations.8
Key Takeaways
- Government sponsored enterprise bonds are debt instruments issued by federally chartered, privately-owned entities like Fannie Mae and Freddie Mac.
- They aim to provide liquidity and stability to specific credit markets, predominantly housing.
- While not explicitly guaranteed by the U.S. government, these bonds often trade with a yield premium over U.S. Treasury bond, reflecting their perceived implicit government backing.
- Their market stability was tested during the 2008 financial crisis, leading to government conservatorship for the largest housing GSEs.
- Investors consider government sponsored enterprise bonds to be relatively low-risk fixed income investments, suitable for portfolio diversification.
Interpreting the Government Sponsored Enterprise Bond
The yield on a government sponsored enterprise bond is a key metric for interpretation. It reflects the return an investor can expect relative to the bond's price. Due to their perceived government backing, government sponsored enterprise bonds generally offer yields that are higher than those of U.S. Treasury bonds but lower than those of similarly rated corporate bonds. This "spread" over Treasury bonds compensates investors for the slightly higher, albeit still low, default risk and any differences in liquidity.
When evaluating a government sponsored enterprise bond, investors consider factors such as its maturity date, coupon rate, and how its yield compares to other fixed income securities. The yield spread can indicate market perception of the GSE's financial health and the strength of the implicit government backing. A widening spread might suggest increased perceived risk or changes in market sentiment regarding the GSE's status.
Hypothetical Example
Consider an investor, Sarah, who is looking for a low-risk fixed income investment that offers a slightly higher yield than a Treasury bond. She decides to purchase a government sponsored enterprise bond issued by Fannie Mae.
Suppose the bond has a face value of $1,000, a coupon rate of 3.5%, and a maturity of 10 years. This means the bond pays Sarah $35 in interest annually (3.5% of $1,000). At the time of purchase, a comparable 10-year U.S. Treasury bond is yielding 3.0%. The Fannie Mae bond's 3.5% coupon offers Sarah a 0.5% (or 50 basis points) yield premium. This additional yield compensates Sarah for the slight difference in credit perception between a direct government obligation and a government sponsored enterprise bond, despite the latter's strong implicit backing. Should interest rate risk increase over the bond's life, the market value of Sarah's bond would typically decrease, and vice versa.
Practical Applications
Government sponsored enterprise bonds are widely used by institutional investors, such as pension funds, insurance companies, and banks, due to their credit quality and liquidity. They also find a place in individual investor portfolios, particularly those seeking stable income and moderate risk.
- Portfolio Diversification: For investors seeking to diversify their fixed income holdings beyond U.S. Treasury securities, government sponsored enterprise bonds offer a slight yield pick-up with comparable credit quality.
- Mortgage Market Support: These bonds are fundamental to the U.S. housing finance system. The proceeds from their issuance allow GSEs like Fannie Mae and Freddie Mac to purchase mortgages from lenders, thereby providing continuous liquidity to the primary mortgage market.7 Data from the Federal Reserve Economic Data (FRED) shows the significant volume of mortgage-backed securities held by Fannie Mae, underscoring their critical role in the housing sector. https://fred.stlouisfed.org/series/WSHOFNBS
- Collateral: Given their low credit risk, government sponsored enterprise bonds are often used as collateral in various financial transactions, including repurchase agreements.
Limitations and Criticisms
Despite their advantages, government sponsored enterprise bonds and the entities that issue them have faced criticisms, primarily regarding their implicit government backing and the moral hazard it creates. The assumption that the government would intervene to prevent a default has allowed GSEs to borrow at lower rates than pure private entities, potentially encouraging riskier behavior.6
The financial crisis of 2008 highlighted these vulnerabilities. Prior to the crisis, the GSEs engaged in purchasing subprime mortgages, contributing to their financial instability when the housing market collapsed.4, 5 Their subsequent conservatorship by the FHFA required significant taxpayer support, leading to calls for reform of the GSE structure to reduce taxpayer exposure and foster more private sector involvement in the mortgage market.2, 3 Critics argue that the blurred lines between public mission and private profit incentives led to excessive risk-taking and ultimately, a substantial cost to taxpayers.1 The Federal Reserve Bank of San Francisco also explored the broader economic implications of the mortgage meltdown, pointing to the deep interconnections between housing, financial markets, and the wider economy during the crisis. https://www.frbsf.org/economic-research/publications/economic-letter/2008/november/mortgage-meltdown-economy-public-policy/
Government Sponsored Enterprise Bond vs. Mortgage-Backed Security
A government sponsored enterprise bond is a direct obligation of a GSE, meaning the GSE itself promises to pay the bondholder interest and principal. These bonds typically fund the GSE's general operations, including its purchases of mortgages.
A mortgage-backed security (MBS), while often issued by a GSE, represents an ownership interest in a pool of mortgages. When a GSE issues an MBS, it bundles a large number of individual mortgages and sells claims on the cash flows generated by these mortgages to investors. The GSE typically guarantees the timely payment of principal and interest to MBS holders, even if the underlying mortgage borrowers default. So, while a government sponsored enterprise bond is a corporate bond-like debt of the GSE, an MBS is a securitization product where the GSE acts as a guarantor and servicer of the underlying mortgage pool. Both are crucial to the capital markets but differ in their fundamental structure and the nature of the claim an investor holds.
FAQs
Are government sponsored enterprise bonds backed by the U.S. government?
Government sponsored enterprise bonds are not direct obligations of the U.S. government. However, they are issued by entities with federal charters and a public mission, which historically has led to a perception of implicit government backing. This perception was reinforced by the government's intervention during the 2008 financial crisis to support Fannie Mae and Freddie Mac.
What are the main types of government sponsored enterprises that issue bonds?
The most well-known government sponsored enterprises that issue bonds are Fannie Mae and Freddie Mac, which are crucial to the U.S. housing finance market. Other GSEs include the Federal Home Loan Banks (FHLBanks) and the Farm Credit System.
How do government sponsored enterprise bond yields compare to U.S. Treasury bonds?
Typically, government sponsored enterprise bond yields are slightly higher than those of comparable U.S. Treasury bond. This difference, known as a yield spread, reflects the marginal difference in credit risk and liquidity compared to the direct obligation of the U.S. government.
Who typically invests in government sponsored enterprise bonds?
A wide range of investors purchase government sponsored enterprise bonds, including banks, mutual funds, pension funds, insurance companies, and foreign central banks, due to their relatively high credit quality and liquidity. Individual investors may also hold them directly or through bond funds.