Now that you understand Treasury securities (the safest bonds), you can see how agency securities occupy the next rung on the safety ladder; still very safe, but with a key distinction in government backing.
What Are Agency Securities?
- Issued by government-sponsored enterprises (GSEs) or federal agencies
- Most are NOT directly backed by the U.S. government
- Considered very safe but carry slightly more credit risk than Treasuries
- Primarily focused on the housing market (mortgages)
Key Agencies and Government Backing
This is one of the most tested distinctions on the SIE exam:
| Agency | Full Name | Government Backing | Type |
|---|---|---|---|
| GNMA (Ginnie Mae) | Government National Mortgage Association | Full faith and credit (explicit) | Government corporation |
| FNMA (Fannie Mae) | Federal National Mortgage Association | Implied only (not explicit) | GSE |
| FHLMC (Freddie Mac) | Federal Home Loan Mortgage Corporation | Implied only (not explicit) | GSE |
Key distinction:
- Ginnie Mae is a wholly owned government corporation; its securities carry the same explicit guarantee as Treasuries
- Fannie Mae and Freddie Mac are government-sponsored enterprises that were placed under federal conservatorship in 2008, but their backing remains implied, not legally guaranteed
Exam Tip: Gotchas
- Only GNMA has the full faith and credit backing of the U.S. government. Fannie Mae and Freddie Mac have implied backing only. This is a frequently tested distinction; if the exam asks which agency security is "backed by the full faith and credit of the U.S. government," the answer is always Ginnie Mae.
Mortgage-Backed Securities (MBS)
Pass-through certificates are the most common type of MBS:
- A bank pools together many individual mortgages
- The pool is sold to investors as a single security
- Monthly mortgage payments (principal + interest) pass through to investors
- Investors receive monthly payments (unlike semiannual payments for most bonds)
Key Risks of MBS
| Risk | What Happens | When It Occurs |
|---|---|---|
| Prepayment risk | Homeowners refinance, returning principal early | When interest rates fall |
| Extension risk | Fewer refinancings, extending the security's life | When interest rates rise |
- Prepayment risk is the primary concern; when rates drop, homeowners refinance, and investors get their principal back earlier than expected and must reinvest at lower rates
- Extension risk is the opposite; when rates rise, nobody refinances, so the security lasts longer than expected while yielding below-market rates
Think of it this way: Imagine you lent money to a friend expecting repayment in 5 years. If rates drop, your friend refinances and pays you back in 2 years; now you have to re-lend at lower rates (prepayment risk). If rates rise, your friend holds on as long as possible, and you are stuck earning below-market interest for longer than expected (extension risk).
Exam Tip: Gotchas
- Prepayment risk occurs when rates FALL (homeowners refinance), not when rates rise.
- Extension risk occurs when rates RISE (nobody refinances), not when rates fall.
- MBS pay monthly (not semiannually like most bonds).
Asset-Backed Securities (ABS)
- Similar structure to MBS, but backed by pools of non-mortgage assets
- Common underlying collateral: auto loans, credit card receivables, student loans
- Same pass-through structure, same prepayment and extension risks
Collateralized Mortgage Obligations (CMOs)
CMOs add complexity on top of basic MBS:
- Divide MBS cash flows into tranches (slices) with different maturities and risk profiles
- Each tranche receives principal payments in a specific order
- Designed to give investors more control over maturity and risk exposure
Key tranche types:
| Tranche Type | Prepayment Risk | Cash Flow Predictability |
|---|---|---|
| PAC tranches (Planned Amortization Class) | Lower | More predictable |
| Companion tranches (Support tranches) | Higher | Less predictable |
How Cash Flows Through the Tranches
Think of it as a tower of cups. Mortgage principal payments pour in from the top:
- The PAC tranche fills first, according to a planned payment schedule (the PAC band)
- Any excess principal from faster-than-expected prepayments overflows down to the companion tranche
- When prepayments are slower than expected, the companion receives little or no principal, with the available cash going to keep the PAC on schedule
The result: PAC tranches receive predictable cash flows across a wide range of prepayment speeds. All the variability (both prepayment and extension risk) concentrates in the companion tranche.
Think of it this way: If principal arrives faster than scheduled, the PAC gets its planned amount and the companion absorbs the rest. If principal arrives slower than scheduled, the PAC still gets its planned amount and the companion absorbs the shortfall by extending.
- Companion tranches absorb most of the prepayment and extension risk, shielding PAC tranches
- CMOs are complex securities and are generally NOT suitable for most retail investors
Exam Tip: Gotchas
- Companion tranches absorb the most risk; Planned Amortization Class (PAC) tranches are more stable and predictable.
- CMOs do NOT eliminate prepayment risk; they redistribute it among tranches.