WHAT IS AN AGENCY BOND?

You can buy various securities issued by government-sponsored and government-owned corporations that—strictly speaking—are not actually a part of the U.S. Government. These agencies are affiliated with, but separate from, the U.S. Government.

This tutorial will introduce you to three of these agencies—the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC—although there are several other, less well-known agencies that also issue bonds. These include World Bank-related agencies and those that package student loans. The three agencies' nicknames—Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC)—refer to the agencies' bonds as well as to the agencies themselves.

Because of their government affiliation, agency bonds are very secure, essentially backed by the full faith and credit of the U.S. Government. Also, thanks to their government affiliation, agencies receive favorable treatment in several arenas: They receive low interest rates on money they borrow, have low capital requirements, and are exempt from state and local taxes. As a result, government agencies sometimes can offer investors more favorable bond earnings than would otherwise be possible.

GNMA, FNMA, and FHLMC all buy mortgages from financial institutions that make loans, and then they group them into pools. They then sell unit shares in these pools to investors. For example, suppose you buy a house or apartment building, taking out a mortgage loan to complete the deal. The term of the loan may vary from 15 to 30 years, and the interest rate may be fixed or adjustable. A government mortgage agency then may buy your mortgage from your bank and combine it with other mortgages to create a pool of $1 million or more. The agency then may issue bonds on these pools through financial institutions, marketing them through brokers. The bonds thus raise additional capital for the agency to replenish its resources, as well as to buy and support additional mortgages.

Agency bonds generally offer a higher return than Treasury securities, along with higher volatility as the market for mortgage-backed securities responds to changes in mortgage rates. If you invest in agency bonds, you receive earnings when the mortgages in the pool are paid off. The minimum investment requirement may be $25,000 or more.