Bonds #27: Yield Pickup: Government Agencies…

…the best of both worlds?

Many believe that stock investments may MAKE your fortune, but bond investments should PRESERVE your fortune.

And, many believe that those bond investments should be very free of credit risk. For them, anything less than AAA-rated government bonds are a cause for insomnia.

Does this mean that they can buy only Treasury bonds? Is there no way they can get the extra yield of corporate bonds without giving up the AAA rating so dear to their hearts?

Bonds issued by agencies of the US government may let them have their cake and eat it, too.

But, not all AAA government bonds are equal!

Treasuries are issued by the government itself, AAA and government guaranteed.

“Agency paper” is issued by corporations sponsored by the federal government.

These securities are obligations of the issuing agency. Unlike Treasuries, they are not backed by the “full faith and credit” of the U.S. government. They do, however, have an implied AAA rating.

The U.S. Congress created six main Federal Agencies that issue bonds:

Federal Home Loan Banks

U.S. Farm Credit System

SLMA “Sallie Mae”

GNMA “Ginnie Mae”

FNMA “Fannie Mae”

FHLMC “Freddie Mac”

But how much extra yield can one get from buying agency paper?

It depends on which type of agency:

GNMAs are in a separate category from other agency paper because they “package” mortgages that ARE backed by the full faith and credit of the government. BUT, they pay off monthly, and the amount can fluctuate as interest rates move. And they will pay you back quicker if rates are low.

Other agency paper pays interest on a semi-annual basis (just like Treasuries and corporate bonds) and pays back the face amount of the bond on maturity date. Some can be “called” by the issuer (they can pay you back early) but you can buy non-call bonds to avoid this risk. That’s what we’ll look at today.

Let’s look at some real-life examples:

5-Year Bonds:

Recently, my screens showed that a Treasury bond maturing in five years yielded 5.58%.

An agency bond traded 0.85% higher, or 6.43%.

GNMA paper with an estimated average life of about five years was even higher, at 6.80%.

10-Year Bonds:

A ten-year Treasury bond yields about 5.60%.

Agency bonds yield 1.10% more, or 6.70%.

GNMA paper with an average life of about ten years was +1.60% over Treasuries, or 7.20%.

This is not bad for AAA paper, since single A2 Ford Motor Credit bonds maturing in ten years have a yield about 2.20% (called 220 basis points) over Treasuries, or 7.80%.

So, while they don’t have the safety of Treasury bonds or the high yields of corporate bonds, it may be that government agencies give you the best of both worlds!