Agency Securities: Understanding Federal Agency and GSE Debt Instruments

3.2.4 Agency Securities

Agency securities represent an important segment of the debt securities market, offering unique characteristics and benefits that distinguish them from other fixed-income investments. Understanding these securities is crucial for those preparing for the Securities Industry Essentials (SIE) Exam, as they form a significant part of the exam’s coverage on debt securities. This section will delve into the definition, issuers, characteristics, benefits, risks, tax considerations, and exam relevance of agency securities.

Definition and Issuers

Agency securities are debt obligations issued or guaranteed by federal agencies and government-sponsored enterprises (GSEs). These entities play a pivotal role in the financial markets by providing liquidity and stability, particularly in the housing sector.

Federal Agencies

• Ginnie Mae (GNMA): The Government National Mortgage Association, commonly known as Ginnie Mae, is a federal agency within the U.S. Department of Housing and Urban Development (HUD). It guarantees mortgage-backed securities (MBS) that are backed by federally insured or guaranteed loans, such as those from the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA). Ginnie Mae securities are backed by the full faith and credit of the U.S. government, making them one of the safest investments available.

Government-Sponsored Enterprises (GSEs)

• Fannie Mae (FNMA): The Federal National Mortgage Association, or Fannie Mae, is a GSE that provides liquidity to the mortgage market by purchasing mortgages from lenders and issuing MBS. Although not backed by the full faith and credit of the U.S. government, Fannie Mae has an implicit guarantee due to its government charter.

• Freddie Mac (FHLMC): The Federal Home Loan Mortgage Corporation, known as Freddie Mac, operates similarly to Fannie Mae, buying mortgages and issuing MBS. It also benefits from an implied government backing.

• Federal Home Loan Banks: This network of regional banks provides liquidity to member financial institutions to support housing finance and community investment. They issue consolidated debt obligations, which are considered very safe investments due to their government sponsorship.

Characteristics

Agency securities, particularly mortgage-backed securities (MBS), have unique attributes that make them attractive to investors.

Mortgage-Backed Securities (MBS)

MBS are bonds secured by pools of home loans. They are pass-through securities, meaning investors receive monthly payments of principal and interest. The cash flows from these securities depend on the payments made by the borrowers of the underlying mortgages.

• Pass-Through Securities: Investors receive a share of the payments from the mortgage pool, which includes both principal and interest. This structure provides a steady income stream.

• Collateralized Mortgage Obligations (CMOs): A type of MBS that divides the mortgage pool into tranches with varying maturities and risk levels. CMOs offer more predictable cash flows than traditional pass-through securities.

Credit Quality

• Ginnie Mae: As Ginnie Mae securities are backed by the full faith and credit of the U.S. government, they are considered to have the highest credit quality.

• Fannie Mae and Freddie Mac: While these GSEs are not explicitly backed by the government, they are perceived to have strong credit quality due to their government ties and historical support.

Benefits

Agency securities offer several advantages that make them appealing to investors seeking fixed-income investments.

Income

• Monthly Payments: Investors in MBS receive monthly payments, which can be attractive for those seeking regular income.

• Higher Yields: Agency securities often offer higher yields compared to U.S. Treasury securities, making them an attractive option for income-seeking investors.

Variety

• Different Structures: Agency securities come in various forms, such as traditional pass-through MBS and more complex structures like CMOs, providing investors with a range of options to suit their risk tolerance and investment objectives.

Risks

Despite their benefits, agency securities are not without risks. Understanding these risks is crucial for exam preparation and investment decision-making.

Prepayment Risk

Prepayment risk arises when borrowers pay off their mortgages early, typically in a declining interest rate environment. This can lead to a reduction in the expected interest income for investors, as the principal is returned sooner than anticipated.

Extension Risk

Extension risk occurs when borrowers slow down their repayments, often in a rising interest rate environment. This can result in a longer investment period than initially expected, potentially leading to lower returns if interest rates rise.

Credit Risk

While credit risk is minimal for agency securities, it is not entirely absent, particularly for GSEs like Fannie Mae and Freddie Mac, which do not have an explicit government guarantee.

Tax Considerations

The interest earned on agency securities is subject to federal and state taxes. Investors should consider the tax implications when evaluating these securities as part of their investment strategy.

Agency Securities and the SIE Exam

For the SIE Exam, it is essential to understand the types and features of agency securities, recognize the issuers and their respective backing, and be aware of the specific risks involved, especially prepayment and extension risks. Familiarity with these concepts will help candidates answer related questions accurately.

Glossary

• Agency Security: A debt obligation issued by a federal agency or GSE.
• Mortgage-Backed Security (MBS): An investment backed by mortgages.
• Prepayment Risk: Risk that loans underlying a security are paid off early.
• Extension Risk: Risk that borrowers will slow down repayments, extending the investment period.

References

• SEC’s Investor Bulletin: Mortgage-Backed Securities
• Investopedia - Agency Securities: Agency Bonds

SIE Exam Practice Questions: Agency Securities

By understanding agency securities, their issuers, characteristics, benefits, risks, and tax implications, you are better prepared to tackle related questions on the SIE Exam. This knowledge will also serve as a foundation for your career in the securities industry, where these instruments play a significant role in the fixed-income market.