Institutional bonds: limited risks and higher returns

In the world of fixed-income securities, institutional bonds are one of the safest investments, and because of their low risk and high liquidity, they are often compared with T-bonds. But unlike government bonds issued only by the Ministry of Finance, institutional bonds come from multiple sources, including not only government agencies, but also certain government-authorized companies. In this article, we will examine the different types of institutional debt, the tax issues involved in each type of debt, and learn about the many options available to individual investors seeking unique bond structures.

notes: The term “national debt” in this article includes all debt issued by the U.S. Treasury Department, including national debt, national debt and national debt.

Agent bond issuer
Not all agency bonds are issued by government agencies; in fact, the largest issuer is not an agency itself, but a government-sponsored entity (GSE). This is an important difference, because real institutions clearly have the full trust and credit support of the U.S. government (making their default risk almost as low as national debt), while GSEs are private companies that hold government licenses because their activities are controlled by the government. Think it is important to public policy.

Among other things, these companies provide home loans, agricultural loans, student loans and help fund international trade. Since the government first paid special attention to these activities by granting concessions, the market generally believed that the government would not allow the concession holding company to fail—thus providing an implicit guarantee for GSE debt. Although institutional bond traders recognize this difference between real institutions and GSEs when buying and selling bonds, the yields on the two types of debt are often almost the same.

In the table below, we see two hypothetical proxy bonds issued by bond dealers. Federal Farm Credit Bank (FFCB) is a GSE and therefore implicitly guarantees its debt, while Private Export Funding Corp. (PEFCO) bonds are backed by U.S. government securities (held as collateral), and interest payments are treated as explicit Obligations of the U.S. government. However, in the yield to maturity (YTM) line, one can clearly see that in the market, the values ​​of implicit and explicit guarantees are very similar, resulting in almost the same returns.

—— Agency deposit 1 Institutional bonds 2 National debt
Issuer FFCB Oil company U.S. Department of the Treasury
GSE or agency GSE mechanism
maturity 2/20/2009 2/15/2009 2/28/2009
coupon 5.08 3.375 4.75
Inquiry* 100.589 97.467 100.413
Yield to maturity (YTM)* 4.760 4.753 4.53
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Although they have government guarantees (implicit or explicit), the transaction yield (spread) of agency bonds is higher than that of comparable government bonds. In the above example, FFCB bonds are provided to Treasury bonds at a spread of 23 basis points (4.76%-4.53% = 0.23%), while the spread of PEFCO bonds only exceeds 22 basis points.

There are several reasons why investors should expect agency bonds to have higher yields than Treasury bonds:

  1. There are some additional risks, no matter how slight, stemming from political risks, that is, the government’s guarantees for agency debt may be modified or revoked in the future, making bonds more prone to default.
  2. National debt is arguably the most liquid financial instrument on the planet. Central banks and other large institutions that need to be able to buy and sell large amounts of securities very quickly and efficiently use it. On the other hand, the institutional liquidity and transaction efficiency are not high.

For example, if a large fund or government wants to buy $1 billion in 10-year bonds, it can easily complete the order using Treasury bonds, and may even find the amount in a single bond issuance, but if it tries to buy institutional bonds instead, the order will be It has to be divided into many smaller problem blocks, which means more time and less efficient processes. Of course, this is usually not a problem for individual investors who purchase much smaller quantities.

State tax issues
Perhaps the most critical issue for any investor living in a state that levies its own state tax on top of federal taxes is the state tax on different agency bonds.Although the debt coupon payments of the most well-known institutions (Fannie and Freddie Mac) are taxable at the federal and state levels, other institutions are taxable if only At the federal level.

Contrary to intuition, the yields of fully taxable and national tax-exempt agency bonds are often very similar, if not equal. Although one might think that agency bonds that are not taxed at the state level are more expensive than those that are fully taxable (thus offsetting part of the proceeds-just like municipal bonds, municipal bonds are usually more expensive due to their privileges). , But this is not always the case.

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—— Agency deposit 1 Institutional bonds 2 National debt
Issuer Fannie Mae FHLB U.S. Department of the Treasury
Fully taxable or state exempt Fully taxable State tax exemption
maturity 12/15/2016 12/16/2016 11/15/2016
coupon 4.875 4.75 4.625
Inquiry* 99.816 98.854 100.811
Yield to maturity (YTM)* 4.898 4.898 4.52

Since the pre-tax yields of fully taxable and state tax-exempt agency bonds are usually almost the same, it is important to purchase state tax-exempt bonds in an account that is subject to state income tax.

To illustrate this point, the table below shows how cash flow is affected by federal and state taxes. In this example, we pay $100 (face value) for a two-year proxy bond with an annual interest rate of 6%, and then hold it to maturity. Suppose you belong to the 35% federal tax bracket and you live in California, where the state income tax rate is 9.3%.

* Federal tax is lower due to state tax deduction

If we buy bonds that are tax-exempt, our after-tax internal rate of return (IRR) will be 3.9%, but if we mistakenly buy bonds that are subject to state taxes, our yield will drop by 36 basis points to 3.54% .

Choose the bond structure that suits you
Some agencies issued a lot of Debt. For example, the Federal Housing Loan Bank issued bonds worth US$322.5 billion in 2006. Although a large number of ordinary bonds have been issued, the number is staggering, and they are constructed in a more peculiar way to meet the specific needs of investors.

A large part of institutional debt is redeemable. If you think the yield may rise, this may be a good investment. Because redeemable bonds contain embedded call options (executable by the seller), they usually have a higher yield to compensate for the risk of bonds being redeemed. Some redeemable institutional bonds can be redeemed at any time, while others are monthly, quarterly or even only on a specific date before maturity. Or, some agency bonds are issued with putative reserves that can be exercised by bondholders. If the yield rises, this will benefit the purchaser.

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Although embedded call options and put options may be the most important and common rules when buying bonds, there are many other structures and rules to look for. The more common is the tiered structure, in which the coupon rate rises as the bond approaches maturity. Callable bonds are usually accompanied by booster bonds, making them more likely to be redeemed when the coupon rate rises (because the issuer is more likely to repay the debt when there is a larger coupon to pay).

It also issues floating-rate bonds, whose coupons are regularly reset to interest rates linked to LIBOR, Treasury bond yields or some other specific benchmarks. Other coupon variants are also available, including monthly coupon payments or maturity interest bonds (similar to zero coupon bonds). It is also possible to use bonds with a death penalty clause, where the deceased bondholder’s estate can redeem the bonds at face value.

Who’s Who of Institutional Bonds
The following table shows the basic information of each issuer. The top four account for more than 90% of the total outstanding debt of the institution and are the most common issuers when investors buy bonds.

Symbol full name GSE/Organization Coupon income is taxable in the country
FHLB Federal Housing Loan Bank GSE No
FHLMC Federal Home Mortgage Corporation (Freddie Mac) GSE Yes
National Monetary Administration Federal National Mortgage Association (Fannie Mae) GSE Yes
FFCB Federal Agricultural Credit Bank GSE No
Reference Resolution to fund the company GSE No
Television Broadcasting Company Tennessee Valley Authority GSE No
Fico Financing company GSE No
Oil company Private Export Finance Corporation mechanism Yes
General Technical Committee Government trust certificate GSE Yes
assistance Agency for International Development mechanism Yes
FAC Financial Aid Company mechanism No
GSA General Services Administration mechanism No
Small Business Administration Small Business Administration mechanism Yes
U.S. Postal Service United States Postal Service GSE No

in conclusion
Institutional bonds give individuals and institutions the opportunity to obtain higher returns than Treasury bonds, while at the same time making little risk or liquidity sacrifices. In addition, a large number of bond structures in agency products allow buyers to customize their investment portfolios according to their own circumstances.


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