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Course 109
U.S. Government Agency Bonds

Introduction

While many people are more familiar with U.S. savings bonds and Treasuries, U.S. government agency bonds can also contribute to your investment portfolio. As a savvy investor, you should be familiar with three key members of the government agency bond family--Ginnie Mae, issued by the Government National Mortgage Association (GNMA); Fannie Mae, issued by the Federal National Mortgage Association (FNMA); and Freddie Mac, issued by the Federal Home Loan Mortgage Corporation (FHLMC).

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.

Three of these agencies are the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC). There are other agencies, including World Bank-related agencies and those that package student loans, that also issue bonds, but we will focus on the first three due to their notoriety. 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. Agency bonds are very secure, essentially backed by the full faith and credit of the US government.

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 most 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.

What Is a Ginnie Mae?

The Government National Mortgage Association (GNMA) operates as an agency of the U.S. Department of Housing and Urban Development.

It buys home mortgages from the financial institutions that made these loans and groups them into pools of $1 million or more. Ginnie Mae either keeps these pools to sell directly to investors or sells the pools to mortgage bankers and other institutions, which market them to investors.

Ginnie Mae or the mortgage banker continues to collect mortgage payments from the homeowners in each pool, and when you invest in a Ginnie Mae, you usually receive a monthly payment that includes both interest and a portion of the outstanding principal. Alternatively, you may receive monthly payments including only interest, and then receive the principal back when the mortgage matures.

These government agency bonds are also sometimes called Ginnie Mae pass-through securities, since the mortgage payments pass through a bank, which takes a fee before passing the remainder of the payments to investors.

Besides providing a higher return than Treasury notes and having the U.S. government's backing against default, Ginnie Maes have another advantage: they are highly liquid and can be resold on the secondary market.

The minimum investment for a Ginnie Mae is generally $25,000. Thereafter, the securities are available in increments of $1. Of course, you sometimes can buy Ginnie Maes that are selling for less than $25,000 at a discount on the secondary market, if their interest rates are low compared to more recent issues or if their principals have been substantially reduced. Finally, you can purchase shares in Ginnie Mae mutual funds for less than $25,000. Ginnie Mae funds or investment trusts buy these government agency bonds and offer shares to the public.

In addition to individual investors, a wide variety of organizations buy Ginnie Maes--for example, retirement pension funds, credit unions, real estate investment trusts, commercial banks, insurance companies, and corporations. Likewise, many different types of institutions issue Ginnie Maes--including mortgage companies, banks, and credit unions. Ginnie Maes are readily available and easy to add to your portfolio.

What Are Fannie Maes and Freddie Macs?

Fannie Mae (Federal National Mortgage Association--FNMA) and Freddie Mac (Federal Home Loan Mortgage Corporation--FHLMC) are operated through the U.S. Department of Housing and Urban Development. They are former federal agencies that became independent entities and are now even listed on the New York Stock Exchange (NYSE). Yet they retain many government connections and support in the form of favorable interest rates, low capital requirements, and tax exemptions.

Fannie Mae got its start during the Great Depression, when Congress created the Federal National Mortgage Association in 1938 to make more dollars available for home loans to middle- and low-income citizens. In 1960, FNMA became partially separated from the government, then later went public and was listed on the NYSE in 1970. Yet, some government connections remain, and five of Fannie Mae's 18-member board of directors are appointed by the U.S. president.

Congress chartered Freddie Mac in 1970, and it went fully public in 1989. The youngster in the family, Freddie Mac has a smaller share of the mortgage market. But partly because of its smaller market share, it is currently growing faster than Fannie Mae is.

Freddie Mac and Fannie Mae create mortgage pools that are somewhat larger than those of Ginnie Mae (Government National Mortgage Association--GNMA), and investors look to them to also provide a relatively high return compared to other government securities.

What Can You Expect to Earn from Agency Bonds?

Investors who purchase U.S. government agency bonds often point out that, over time, they tend to perform somewhat better than Treasury securities. Yet when fewer U.S. Treasuries are issued, government agency bonds also can fill the need for these types of investments.

Contrarians will argue that the volatility of government agency bonds makes them a poorer investment than, say, blue chip stocks. This volatility stems from the possibility that a number of homeowners represented in the mortgage pool might decide to prepay their mortgages for any number of reasons: they may sell their home, refinance it if mortgage interest rates fall, or simply decide to pay down the principal.

When a number of mortgages in the pool are paid before maturity, the investor receives payments of interest and principal sooner than planned. This can be a problem if the investor had counted on a certain fixed rate of return, and if the investment matures early at a time when interest rates on similar investments are low.

Yet many investors continue to purchase Ginnie Maes, Fannie Maes, and Freddie Macs, attracted by their respectable long-term performance and low risk of default.

Government Agency Bonds and Safety?

While government agency bonds are extremely solid investments, backed implicitly by the U.S. government, they are, of course, slightly less solid than investments in Treasury securities. And because Ginnie Mae is operated through a U.S. agency--the Department of Housing and Urban Development--its bonds are considered slightly more solid than those of Fannie Mae and Freddie Mac. Both Fannie Mae and Freddie Mac are former government agencies that now are publicly traded companies chartered by Congress. For all practical purposes, however, all of these securities are as strong as Plymouth Rock.

Yet investors in U.S. government agency bonds still face certain risks. Perhaps the biggest of these is prepayment risk. Prepayments directly affect an investment's average life and yield. And accurately predicting the home mortgage interest rates five or more years out is as much of a challenge as correctly forecasting a bull or bear market.

Just the opposite happens when mortgages in the pool mature more slowly. If fewer homeowners sell their home or refinance, for instance, the average life of the investment grows longer than planned. This extension risk reduces the amount of money with which the investor has to buy other securities at a time of high interest rates.

Investors who trade U.S. Government agency bonds on the secondary market also face market risk--much as they would with common stocks. The value of their investment can vary according to such factors as changing interest rates, time to maturity, and liquidity.

Despite these risks, many individual investors and organizations buy U.S. government agency bonds. They believe that the low likelihood of default coupled with a generally reasonable return compensates them for the potential volatility and other risk factors.

Invest in Federal Agencies with Government Bonds

Looking back, U.S. government agency bonds have evolved considerably over the years. Ginnie Mae, Fannie Mae, and Freddie Mac all began their existence as federal agencies. While the first of the three is still operated under the U.S. Department of Housing and Urban Development, the latter two have become much more independent entities. And the future promises additional changes. Among the possibilities Fannie Mae and Freddie Mac are considering: mortgages that could be portable from one house to the next or mortgages with rates that drop when the owner regularly pays on time. Stay tuned. The world of personal finance continuously offers new landscapes and shifting panoramas.

Quiz 109
There is only one correct answer to each question.

1 Which of the following is one advantage of government agency bonds?
a. Low minimum investment requirement
b. Higher yields than those of Treasury securities
c. High minimum investment requirement
2 The minimum initial investment in a Ginnie Mae is...
a. $35,000
b. $25,000
c. $50,000
3 Which of the following is one way you can purchase your first Ginnie Mae for less than $25,000?
a. From your regional banker
b. Through the U.S. Treasury discount system
c. On the secondary market
4 When many mortgages in an investment pool are prepaid, what problem might the investor face?
a. Reinvesting the money in another security that provides a lower interest rate
b. Being locked in to a poorly performing investment
c. High commissions on future bond purchases
5 Homeowners are least likely to prepay their mortgages when they?
a. Refinance their homes
b. Sell their homes
c. Take out a home equity loan
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