Agency Bonds Look Very Attractive

I find agency bonds particularly attractive here.

I've stored a lot of my money in cash and money market funds over the last several years.  With rates between 5 and 6%, this has been a solid way to preserve the money that I cannot afford to lose.  I believe that rates may be about to decline sharply (a move could result from Thursday's decline in short-term Treasuries).

On Friday, I start to move my money into US agency bonds.  Here's why:

Agency bonds trade at a premium over Treasuries because they are not backed by the US Full Faith and Credit.  Most believe that in the event of a failure, the US government would bail out bondholders.  Nevertheless, this is a risk that should be borne in mind and it is probably most prudent to divide your exposure between a handful of fagencies.

I buy agency bonds that are state and local tax exempt - such as Federal Home Loan Mortgage Association (FHLM), Federal Farm Credit Bank (FFCB) and Tennessee Valley Authority (TVA).  Since I live in New York City, this is a measurable tax savings over comparable instruments.

On Friday, yields on these bonds should have fallen with the market.  They didn't.  I attribute this to a slightly widening risk premium, but more to the fact that everyone is scared and it is summer.   Particularly, anything with the words home and mortgage in it isn't going to get a bid right now, even if it is a government agency.  I should note that the calculated prices on agencies that I own, including FHLM, increased dramatically between Thursday and Friday.

The most interesting thing that I found on Friday were 12-year Federal Farm Credit Bank bond with a 6.40% coupon trading at par. 

The risk in this bonds to me is not that of a default.  The risk is that they are long term and I could get stuck holding bonds that are underwater if interest rates shoot higher (same risk as a long a Treasury).  There is also a risk that the would be called in 1-year if interest rates go lower and the agency can refinance at a lower rate (they are callable and therefore will never appreciate in value the way that Treasuries might).  In an environment where everyone seems to be losing their principal and with the likelihood of a continued decline in world markets, these are risks that I can take.

 

Ari Socolow
Ari Socolow: Ari Socolow is the Chief Economist and Editor-in-Chief at BestCashCow. He is particularly interested in issues relating to financial literacy and bank transparency. Since co-founding this website in 2005, Ari has been frequently cited in the media as an expert on local and national savings accounts, CD products, mortgage and loan products and credit card rewards products.

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Comments

  • Ralph Smith

    August 22, 2007

    Indeed. These bonds offered a very small premium to Treasuries and to money market funds in the past, but right now they are worth taking a serious look at.

  • WPickering

    August 29, 2007

    The problem with these is that they are not guaranteed by the US government, but only by the agency.

    Also, there is no capital appreciation because they always get called.

    Not for me, but maybe good for pure yield hunters.

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