4.3 Agency Securities

Agency securities are bonds issued by U.S. government agencies or government-sponsored enterprises (GSEs). They offer slightly higher yields than Treasuries while still maintaining high credit quality.

Two Categories of Agency Issuers

1. Government Agencies (Full U.S. Government Backing)

Ginnie Mae (GNMA), Government National Mortgage Association: Full faith and credit of U.S. government

Ginnie Mae is the only mortgage-related agency with explicit government backing.

2. Government-Sponsored Enterprises (GSEs)

Fannie Mae (FNMA), Federal National Mortgage Association: Implicit (not explicit) backing

Freddie Mac (FHLMC), Federal Home Loan Mortgage Corporation: Implicit (not explicit) backing

Federal Home Loan Banks (FHLB): Implicit backing

Federal Farm Credit System: Implicit backing

GSEs have implied but not explicit government backing. They were placed in conservatorship in 2008 during the financial crisis.

Key Agency Comparison

Ginnie Mae: Government Backing, full faith and credit; Credit Risk, lowest (same as Treasury); Yield, lowest agency yield; Types of Mortgages, FHA, VA, USDA loans; Status, government agency

Fannie Mae / Freddie Mac: Government Backing, implied only; Credit Risk, slightly higher; Yield, slightly higher; Types of Mortgages, conforming conventional; Status, GSE in conservatorship

Mortgage-Backed Securities (MBS)

Agency securities are primarily mortgage-backed securities, bonds backed by pools of mortgages.

Pass-Through Securities

Pass-through MBS are the most common type:

Structure: Pool of mortgages packaged together

Cash Flows: Principal, interest, and prepayments "pass through" to investors

Payments: Monthly (unlike semi-annual for most bonds)

Prepayment Risk: Primary risk, homeowners can prepay mortgages

How Pass-Throughs Work

1. Thousands of mortgages pooled together

2. Investors buy shares of the pool

3. Each month, mortgage payments flow through to investors

4. Payments include: scheduled interest + scheduled principal + prepayments

Prepayment Risk: The Key Risk for MBS

Prepayment risk is the risk that mortgages will be paid off early, returning principal sooner than expected.

When Prepayment Increases

Interest rates fall: Prepayments increase, homeowners refinance to lower rates

Housing market strong: Prepayments increase, more home sales

Economic strength: Prepayments increase, more moves, upgrades

Why Prepayment Risk Hurts Investors

When rates fall:

1. Homeowners refinance, paying off mortgages early

2. Investors receive principal back sooner than expected

3. Must reinvest at lower rates

4. Lose the higher-coupon investment just when it's most valuable

This is similar to call risk on callable bonds.

Extension Risk

The opposite problem: when rates rise:

1. Homeowners don't refinance

2. Prepayments slow dramatically

3. Average life of MBS extends

4. Investors stuck with below-market yields longer

Collateralized Mortgage Obligations (CMOs)

CMOs restructure MBS cash flows into different classes (tranches) to manage prepayment risk.

Short-term tranches: Receive principal first; lower prepayment risk

Intermediate tranches: Receive principal after short-term paid off

Long-term tranches (Z-tranche): Receive principal last; highest prepayment uncertainty

PAC tranches: Planned Amortization Class; most predictable cash flows

Companion tranches: Absorb prepayment variability; most uncertain

CMOs don't eliminate prepayment risk, they redistribute it among tranches.

Agency Securities Characteristics

Credit Risk: Very low (Ginnie Mae lowest)

Yield: Higher than Treasury, lower than corporate

Prepayment Risk: Primary risk

State Tax: Generally taxable (unlike Treasuries)

Monthly Payments: MBS pay monthly, not semi-annually

Liquidity: Very good, second largest bond market

In Practice: How Investment Advisers Apply This

Portfolio applications:

- Use agency MBS for yield enhancement over Treasuries

- Ginnie Mae for most conservative clients (government backing)

- Consider prepayment risk in rising/falling rate environments

- CMO tranches for specific cash flow matching needs

Client considerations:

- Monthly payments may be attractive for income-focused retirees

- Prepayment risk means uncertain duration

- Extension risk is a concern when rates rise

On the Exam

The Series 65 exam tests your understanding of:

1. Ginnie Mae: Only agency with full government backing

2. Fannie Mae/Freddie Mac: GSEs with implied (not explicit) backing

3. Prepayment risk: Main risk for MBS; increases when rates fall

4. Extension risk: Opposite, prepayments slow when rates rise

5. Pass-through vs. CMO: CMOs redistribute prepayment risk among tranches

Common formats include identifying which agency has government backing and understanding prepayment risk.

Key Takeaways

- Ginnie Mae is the ONLY agency backed by full faith and credit of U.S. government

- Fannie Mae and Freddie Mac are GSEs with implied but not explicit backing

- Prepayment risk is the primary risk for MBS investors

- Prepayments increase when interest rates fall (refinancing)

- Extension risk occurs when rates rise and prepayments slow

- Pass-through MBS pass mortgage payments directly to investors

- CMOs restructure cash flows into tranches with different prepayment characteristics

- Agency MBS are generally state-taxable (unlike Treasuries)