Often offering higher yields than comparable Treasury bonds, agency bonds may be worth considering. Other benefits can include high credit quality, relatively good liquidity, and potential tax advantages.
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Agency bonds are issued by either a government-sponsored enterprise (GSE) or a government-owned corporation, and are debt obligations solely of the issuing agency. GSEs include Federal Home Loan Bank (FHLB), Federal Farm Credit Bank (FFCB), Federal National Mortgage Association (FNMA), and Federal Home Loan Mortgage Corporation (FHLMC). Tennessee Valley Authority (TVA) is a government-owned corporation.
Bear in mind that while agency bonds are considered to have high credit quality, the federal government is under no legal obligation to save a GSE from default. There are two categories of agency bonds: bonds that are the debt of the agencies themselves, and mortgage-backed securities (MBS) that are issued by agencies.
What does Schwab offer?
Why would Schwab recommend agency bonds?
Agency bonds offer investors the opportunity to preserve principal; in addition, they provide relatively high liquidity, some tax advantages, and the potential to earn a higher yield than Treasuries offer.
Schwab provides clear, competitive, and straightforward pricing.
Secondary market agency bonds
Transaction fee of $1 per bond ($10 minimum, $250 maximum per trade*)
Online price + $25 per trade
*Schwab reserves the right to act as principal on any fixed income transaction, public offering or securities transaction. When Schwab acts as principal, the bond price includes our transaction fee (outlined above) and may also include a markup that reflects the bid-ask spread and is not subject to a minimum or maximum. When trading as principal, Schwab may also be holding the security in its own account prior to selling it to you and, therefore, may make (or lose) money depending on whether the price of the security has risen or fallen while Schwab has held it. When Schwab acts as agent, a commission will be charged on the transaction.
Take a closer look at the benefits.
High credit quality
Although agency bonds are not guaranteed by the full faith and credit of the U.S. government, they do involve some level of federal sponsorship and generally have high credit quality—although ratings are always subject to change.
Agency bonds enjoy an active secondary market, so there is usually opportunity to sell before the bonds mature. If you sell agency bonds before maturity, you may receive more or less than you originally paid.
Interest payments from bonds issued by the FHLB, FFCB, and TVA are generally exempt from state and local taxes and are only taxable at the federal level. You should consult your tax advisor about your particular situation.
Agency bonds are subject to the following types of risk: interest rate, credit, call, liquidity, reinvestment, inflation (or purchasing power), market and event, as well as other risks commonly associated with fixed income securities.
It’s important to remember that the issuing agency—not the U.S. government—backs an agency bond. Even so, these bonds still receive very high credit ratings, since they’re viewed by some as moral obligations of the federal government.
The risk that the value of a fixed income security will fall as a result of a change in interest rates. This risk can be reduced by diversifying the maturities of fixed income investments or investing in floating-rate securities.
The risk that a security will default or that its credit rating will be downgraded, resulting in a decrease in value for the security. The measurement of credit risk usually takes into consideration the risk of default, credit downgrade, or change in credit spread.
The risk to bondholders that a call option will be exercised by the issuer at an unfavorable time for the holder, such as when interest rates are low; if you are a bondholder whose security is called, you can lose potential interest income.
The relative ability of a security to be sold without substantial transaction costs or reduction of value. The harder it is to sell a security or the greater the loss in value resulting from a sale, the greater the liquidity risk.
The risk that cash flows from an investment will be reinvested when interest rates are lower, resulting in a possible reduction in cash flow. To help mitigate reinvestment risk, an investor can purchase noncallable bonds, which are not subject to early redemption, or can ladder bond maturities at different intervals over time.
Inflation (or purchasing power)
The risk that inflation will erode the real return on investment. This occurs when prices rise at a higher rate than investment returns and, as a result, money buys less in the future. The risk is greatest if you’re investing over long periods of time. Inflation-protected securities can be used to mitigate inflation risk.
Market and event
The risk that a change in the overall market environment or a specific occurrence, such as a political incident, will have a negative impact on the price or value of your investment.
Whether you invest in new issues or the secondary market, Schwab has a wide range of choices.
Schwab BondSource® lets you research and order new-issue agency bonds online.
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