Sometimes the choice among high-quality bonds comes down to incremental yield—especially in an environment of declining interest rates.
Consider agency bonds, which are issued by government-sponsored enterprises such as the Federal National Mortgage Association (a.k.a. Fannie Mae) and the Federal Home Loan Mortgage Corporation (a.k.a. Freddie Mac). These issuers generally have the same strong credit rating as U.S. Treasury securities. Unlike Treasuries, however, they aren't backed by the full faith and credit of the U.S. government.
"Should an agency face financial hardship, its bonds would generally have a greater risk of default than Treasuries," explains Collin Martin, CFA®, a director and fixed income strategist at the Schwab Center for Financial Research. "This is why agency bonds offer slightly higher yields."
Indeed, the yield on agency bonds historically has been about a quarter of a percentage point higher than Treasuries,1 "though investors typically must buy bonds with maturities of five years or longer to realize this advantage," Collin notes.
The maturity advantage
As things stand now, the longer the time to maturity, the greater the yield advantage agency bonds have over Treasuries.
Source: Bloomberg, as of 02/23/2024.
U.S. Treasury Actives Curve and U.S. Agencies BVAL Yield Curve. The Treasury curve comprises U.S. dollar–denominated U.S. Treasury active securities. The curve is updated on each auction day with an effective date of the next market day. The agency yield curve is constructed daily with bonds that have BVAL prices at the market close. The BVAL curve is populated with U.S. dollar–denominated senior unsecured fixed rate bonds issued by U.S. agencies. Past performance is no guarantee of future results.
What's more, while some agency bonds are taxed the same as Treasuries (meaning they're subject to federal tax but exempt from state and local taxes), bond income from some agencies, including Fannie Mae and Freddie Mac, doesn't enjoy that exemption. "Be sure to factor in after-tax yields when comparing agency and Treasury bonds," Collin says.
Another option to consider is callable agency bonds, which can offer yields of as much as a full percentage point higher than Treasuries—but which pose a different type of risk. Namely, if interest rates fall, the agency may choose to "call" the bond, or pay back the principal prior to maturity, so it can issue new debt at a lower rate.
"Investors whose bonds are called in would be left to replace them with lower-yielding securities, potentially curtailing future income," Collin says. "This is a particularly important consideration as the Federal Reserve has signaled that it expects to cut its benchmark federal funds rate this year."
To research and compare agency bonds, Schwab clients can log in to their account and select Agencies under Bond Type. You can refine your search by maturity date, yield, callable or non-callable, and more.
1Bloomberg U.S. Agency Index, as of 04/22/2024.
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