Fixed Income

Government-Sponsored Enterprise Debt Securities

Traditionally considered high-quality, income-generating vehicles, government-sponsored enterprise securities offer relative safety, predictable income and competitive returns over Treasuries. Government-sponsored enterprises (GSEs) were established by acts of Congress to support various public policies, such as home ownership, farming, education and natural resource development. Although issued by government-created corporations and agencies, GSE debt is not guaranteed by the federal government. This means that payments of interest and principal are solely the obligation of the issuers. One exception exists, however. In 1968, Congress created the Government National Mortgage Association, or Ginnie Mae, and debt securities issued by Ginnie Mae are backed by the full faith and credit of the U.S. government.

In order to support public policies, GSEs purchase new mortgages and other loans from issuers, who then use the proceeds to issue new loans. To continue their missions, GSEs must have access to funds. While some GSEs, such as Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Corporation (Freddie Mac), are publicly traded companies that can issue stock to raise capital, most rely on debt financing or, in the case of Ginnie Mae, borrow directly from the U.S. government. The GSEs issue notes, bonds and mortgage-backed securities via periodic auctions as well as through various securities dealers. The amount of debt issued and the frequency of issuance depend on each GSE’s need for funding. The most active participants are shown in the following table.

¹Ginnie Mae is financed through the U.S. Treasury.

²Freddie Mac and Fannie Mae are currently under FHFA conservatorship; see details in the “Credit Quality” section.

³Some exceptions apply.

⁴Interest payments are guaranteed by the U.S. government; principal is collateralized by U.S. Treasury zero-coupon bonds.

Features and Benefits of GSE Securities

GSE securities are offered in a wide range of maturities and may incorporate a variety of features to meet investor demand. The most common feature is a call, which entitles an issuer, at its option, to pay back the principal before the stated maturity date. Generally, the issuer may call bonds when interest rates decline. New securities may then be offered with lower coupon rates to reduce the issuer’s cost of capital. Callable bonds generally offer higher rates than non-callable alternatives in order to compensate investors for giving the issuer an option to redeem the bonds early.

Another feature is a Survivor’s Option – common to securities offered through medium-term notes programs. In the event of a bond holder’s death, the estate or beneficiary has a right to redeem bonds from the issuer at par plus accrued interest. The issuer may limit the total amount per offering per year to be redeemed. Investors must read a prospectus before investing.

Predictable Income

GSE securities offer predictable interest payments for investors looking to supplement periodic income. Interest payments are made monthly, quarterly, semi-annually or at maturity and are available for other investment opportunities or withdrawal.

Although many GSEs issue notes and bonds with fixed coupon rates, some offer securities with variable interest rates. Based on individual investment objectives, variable-rate bonds may help investors meet future financial needs and create a defensive strategy against a potential rise in inflation and interest rates.

Fixed coupon rate – A fixed coupon rate is set at the time of issuance and does not change until the bond matures. The interest payments are predictable and usually paid semi-annually or monthly.

Zero coupon rate – Bonds that do not pay any interest during their lifetimes are issued at a discount from par value. These securities may be suitable for investors who are trying to meet future financial obligations, such as college tuition, because, at maturity, the issuer will repay the full face value. Since no interest is paid, investors are usually compensated with a higher yield. In addition, investors may be responsible for paying “phantom income” tax – which is tax paid on interest accrued but not received until maturity.

Floating coupon rate – This rate is tied to an interest rate index, such as the Constant Maturity Treasury Index, London Interbank Offered Rate (LIBOR) or Prime Rate, and changes as the corresponding index is reset according to a schedule established at time of issuance. The interest rate is quoted as a certain number of basis points over the index – known as the spread (for example, LIBOR + 50 basis points). Spread is determined at the time of issuance and remains fixed until maturity. As the index adjusts, so do the interest payments – this may happen monthly, quarterly, semi-annually or annually.

Step coupon rate – A step coupon rate changes at predetermined time intervals and usually increases (steps up) in equal increments. The step rate schedule is established at the time of issuance. These securities are generally issued with a call feature. The initial interest rate is paid until the first call date and, if not called, steps to the next level. Step-up bonds may offer lower initial interest rates than comparable fixed-rate securities; however, if not called, they will keep stepping up and may result in a higher total return. This can be a defensive strategy if investors anticipate an increase in market interest rates.

Competitive Returns

For investors concerned with the safety of invested principal but looking for higher return, GSEs generally offer competitive yields over Treasuries and other guaranteed securities, such as CDs.

Credit Quality

GSE debt is not guaranteed by the U.S. government. However, their securities are considered some of the safest fixed income investment alternatives. As of 12/01/2009, senior debt of GSEs is rated “AAA,” while subordinated debt of Fannie Mae and Freddie Mac is currently rated AA-/Aa-. Please contact your financial advisor for current ratings information.

Fannie Mae and Freddie Mac are presently under the Federal Housing Finance Agency’s conservatorship. Deterioration of the housing market has shaken the safety and soundness of these two enterprises and, consequently, has compromised their ability to provide stability and liquidity to the mortgage market. In order to restore investors’ faith and help raise additional capital, the FHFA took control of Fannie Mae and Freddie Mac’s operations. During the conservatorship, both enterprises will continue their normal operations, including interest and principal payments. For more information, please visit fhfa.gov.

State/Local Tax Exemption

Interest income paid by several GSEs is exempt from state and local taxes: FHLB, FFCB, TVA, FICO and REFCORP.

Diversification

GSEs offer securities with competitive yields and lower risks. A wide range of maturities, payment frequencies, coupon structures and other features can potentially help investors realize individual financial objectives and stabilize portfolio returns.

Diversification does not ensure a profit or protect against a loss.

Investment Considerations

As GSE securities evolve and become more complex, investors should have a clear understanding of risks and benefits before investing.

Interest Rate Risk

Prices of GSE securities fluctuate in reaction to changing market interest rates. When rates rise, market prices of existing debt securities fall as these securities become less attractive to investors when compared to higher-coupon new issues. As prices decline, bonds become cheaper, so the overall return, when taking into account the discount, can compete with newly issued bonds at higher yields. When interest rates fall, market prices on existing fixed income securities tend to rise because their future income payments become more attractive when compared to the newly issued bonds with lower coupon rates. The prices of longer-term fixed income securities are more sensitive to changes in interest rates.

Reinvestment Risk

Reinvestment risk is generally the result of declining market interest rates. Callable bonds are more likely to be called if the issuer can offer new bonds at lower rates to save money. Therefore, investors whose bonds mature or are called while interest rates are falling will face the risk of reinvesting proceeds at lower coupon rates. This may have a negative effect on total portfolio returns.

Liquidity

Active secondary markets exist for most GSE securities if investors need access to principal prior to maturity. However, the degree of liquidity depends on the order size, the security’s structure and characteristics, market interest rates, and demand from buyers, among other factors. Securities issued through the medium-term notes program are tailored to specific investor needs and meant to be held to maturity. Therefore, the level of liquidity for these securities may be limited. Additionally, the complexity of floating-rate bonds may also result in limited demand from buyers in the secondary market.

Taxation

Interest income and capital gains/losses from most GSE securities are subject to federal income tax, as well as state and local taxes. Alternative minimum tax (AMT) may also apply. Investors should consult with a tax professional to ensure proper tax reporting.

If you wish to learn more about government-sponsored enterprises and their debt securities, please ask your financial advisor for FINRA’s GSE Debt Securities brochure or visit investinginbonds.com.

To learn more about these types of securities, contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you.

Asset allocation and diversification do not ensure a profit or protect against a loss.

There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise.

U.S. Treasury securities are issued and guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. U.S. government bonds are guaranteed as to the timely payment of principal and interest; however, these securities are subject to market risk if sold prior to maturity.

GSE securities are issued by government-sponsored enterprises (GSE). Payment of principal and interest is solely the obligation of the issuer. These securities, also known as agency securities, are not guaranteed by the U.S. government and are subject to market risk if sold prior to maturity. Mortgage-backed securities and CMOs are priced based on average life. The actual maturity date maybe shorter than than stated. For more information, please review Investor’s Guide to Mortgage Securities and CMOs at finra.org.

A credit rating of a security is not a recommendation to buy, sell or hold and may be subject to review, revision, suspension, reduction or withdrawal at any time by the assigning rating agency. Ratings are subject to change and do not remove market risk.

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

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