1 P r i m e r : Agency Bonds j a n n e y corporat e credit F e b r u a ry 5, 2014 Agencies provide extra yield vs. Treasuries, offer predictable and relatively safe income, and can be a part of a diversified fixed income portfolio. The agency market is one of the most liquid markets globally. While issuance has declined in recent years, secondary trading of these securities continues to be active, attracting investors of all kinds who incorporate the securities into their investment strategies and income needs. While each issuer s relationship to the US government is unique, most agencies operate with high quality credit ratings and many depend on their high ratings to issue debt at lower costs than potential competitors. U S Agency securities, long considered to be among the highest quality fixed income investments, have been a mainstay of institutional and individual fixed income portfolios for many years. While most agency debt is not backed by the US government, agencies have an implied support of the government, given that most entities were put in place by Congress to support some portion of the market: housing, agriculture, and regional lending. As a consequence of challenges in the period, the agency market has changed somewhat, with new regulatory measures in place and new methods for governmental oversight of housing agencies. The US agency market remains one of the most liquid fixed income markets globally. Primary issuance has declined in recent years, partly a consequence of the winding down of Fannie and Freddie s balance sheets. In 2013, over $440B in new US agency debt priced from more than 5,000 issues compared to in 2010, when $1.2 trillion in new debt priced among over 9,000 issues. In the last twelve months, about $700B in par value agency bonds traded, per FINRA s TRACE, with an average daily trading volume of $2B in par value most recently. Given issuers higher ratings and the sizable amount of debt outstanding, the agency market is liquid. New issues are sold in a variety of ways. Shorter maturities are generally sold through competitive auction, while longer maturities are typically marketed using underwriting groups. Large benchmark issues, structured as bullets, come to market in single maturity pieces as large as $5B or even more. Callable issues, step ups, and other structures are marketed in smaller lots, usually through negotiation with the funding desks of the agency issuers. Jody Lurie Corporate Credit Analyst See page 6 for important information regarding certifications, our ratings system as well as other disclaimers. Agency bonds Page 1 Overview of Types There are two types of agency bonds: those issued by government-sponsored entities ( GSEs ) and those issued by US government agencies. GSEs are for the most part federally-chartered, privately-owned corporations, which focus on financing loans to targeted borrowers (e.g. homeowners or farmers). Debt issued by GSEs has an implied guarantee, meaning that the debt is not specifically backed by the full faith and credit of the US government, but US government has a theoretical moral obligation. US government agencies are organizations established by either legislation or executive orders which serve specific functions. While some debt issued by government agencies is backed by the full faith and credit of the US government (e.g. Ginnie Mae debt), other debt is just backed by the issuer s revenues (e.g. Tennessee Valley Authority) or some other source. Features & Structure of Agency Bonds Credit Risk: Because debt issued by GSEs is not backed by the full faith and credit of the US government, but rather only have an implied guarantee, it trades at a slightly higher yield than similarly maturity Treasuries. These yield premiums are a result of credit risk.
2 Total Agency Issuance Has Declined Since the 2010 High $1,400 bln 14,000 $1,200 bln $1,000 bln Amount ($ bln) # Issues (R-Axis) 12,000 10,000 $800 bln 8,000 $600 bln 6,000 $400 bln 4,000 $200 bln 2,000 $0 bln Source: Janney FISR; Filings; FINRA TRACE 0 Bullets and Callable Bonds: Agencies issue both bullets (fixed maturity and no call provision) and callable bonds (callable as early as 3 months after issue, depending on the bond). Investors will require more yield to compensate for possibility calls, so all else being equal, a callable bond should offer a higher yield over a bullet of the same maturity. Primary issuance has declined in recent years, partly a consequence of the winding down of Fannie and Freddie s balance sheets. Step-ups: Step-up bonds are fairly common among agency issuance, particularly in low-rate environments. In such a bond structure, the coupon increases by a set amount on a set date prior to maturity. Typically the issuer has the option to call the bond before the coupon steps up. Zero Coupon Bonds: Fannie and Freddie offer zero coupon bonds which are issued at a discount to their maturity value and pay no periodic interest. These bonds may be issued directly, or can be created in the secondary markets. Taxation: Interest from U S Agency issues is subject to federal income tax, but in some cases is exempt from state and local income taxation. Federal National Mortgage Assoc. (Fannie Mae; FNMA ) Aaa/AA+/AAA Fannie Mae is a government-sponsored enterprise chartered by Congress in 1938 and privatized in Its public mission is to support the secondary mortgage market and increase the supply of affordable housing. FNMA securitizes mortgage loans into mortgage-backed securities that it guarantees. Fannie is the largest single issuer of mortgage-related securities, with 49% market share of new issuance in FY2012. As of December 2012, Fannie owned or guaranteed 29% of the $10.8 trillion US residential mortgage debt outstanding. Along with peer Freddie Mac, Fannie Mae entered into conservatorship in September 2008, operates under the direction of Federal Housing Finance Agency (FHFA), and continues to pay out to the Treasury its positive net worth in the form of a dividend. Fannie Mae currently funds most of its activity through the issuance of notes and bonds, with $534B in total debt outstanding. Federal Home Loan Mortgage Corp. (Freddie Mac; FMCC ) Aaa/AA+/AAA Freddie Mac is a government-sponsored enterprise chartered by Congress in 1970 as means to create a competitor for Fannie Mae. Its public mission is to provide liquidity, stability, and affordability to the US housing market. Like FNMA, FMCC securitizes mortgage loans originated by lenders into Freddie Mac mortgage-backed securities that it guarantees. Along with peer Fannie Mae, Freddie Mac entered into conservatorship in September 2008, and continues to operate under the direction of FHFA and continues to pay out to the Treasury its positive net worth in the form of a dividend. Freddie Mac currently funds most of its activity through the issuance of notes and bonds, with $488B in total debt outstanding. Agency bonds Page 2
3 Fannie is the largest single issuer of mortgage-related securities, with 49% market share of new issuance in FY2012. **Debt issued by Fannie Mae and Freddie Mac is not guaranteed by the federal government, but is considered a moral obligation. Since the recession, Congress has discussed ways to unwind the two entities, most recently proposing a third entity that would assume the role that Fannie and Freddie originally had. Government National Mortgage Assoc. (Ginnie Mae; GNMA ) Aaa/AA+/AAA Ginnie Mae is a US government agency that was established in 1968 when the Fair Housing Act divided Fannie Mae into two separate entities. Unlike Fannie and Freddie, Ginnie Mae does not buy or sell loans or issue mortgage-backed securities (MBS); therefore, Ginnie Mae s balance sheet does not use derivatives to hedge or carry long term debt. Instead, it is in the mortgage guaranteeing business. These loans are insured or guaranteed by the Federal Housing Administration (FHA), HUD, Office of Public and Indian Housing (PIH), Department of Veterans Affairs (VA) Home Loan Program for Veterans, USDA s Rural Development Housing and Community Facilities Programs, and others. Agency Issuance Outstanding & Features Agency Tax Exemption Federal State FNMA No No $534.2 FMCC No No $488.8 FHLB No Yes $767.0 FFCB No Yes $208.1 Debt Security Types Outs ($ bln) Callable Bonds, Bullets, Step-up Notes, Zero Coupon Bonds, Discount Notes, Floating Rate Notes, MBS Callable Bonds, Bullets, Step-up Notes, Zero Coupon Bonds, Discount Notes, Floating Rate Notes, MBS Callable Bonds, Bullets, Discount Notes, Floating Rate Notes Callable Bonds, Bullets, Discount Notes, Floating Rate Notes Farmer Mac No No $12.3 Discount Notes, Bonds, MBS TVA No Yes $26.1 Callable Bonds, Bullets FICO No Yes N/A Bonds, Zero Coupon Bonds (secondary) REFCO No Yes N/A Bonds, Zero Coupon Bonds (secondary) Source: Janney FISR; Company Filings; SIFMA Federal Home Loan Bank ( FHLB ) System Aaa/AA+/NR Chartered by Congress in 1932, the FHLB system is a group of 12 regional cooperative banks that make loans to regional and community banks to support economic development and mortgage lending. For the majority of its member banks, the FHLB system is the most cost-effective way for member banks to access the credit market. Each of the 12 regional FHLBs is self-capitalizing through its member banks, but all are liable for their consolidated obligations (i.e. In the event that an individual FHLB was unable to pay a creditor, the other 11 FHLBs would be required to step in and meet debt obligations). During the recession, the FHLB increased its secured loans to members outstanding to more than $1 trillion, while all other sources of funding dried up. As a result of changes since the recession, the FHFA overseas the FHLB system. As of most recent filings, the FHLB system had $767B in total debt outstanding. Federal Farm Credit Banks ( FFCB ) Aaa/AA+/AAA The Federal Farm Credit Banks was established by Congress in 1916 and is dedicated to lending in agricultural and rural communities through providing loans, leases, and services. The system cur- Agency bonds Page 3
4 rently operates without financial support from the federal government and does not accept deposits; instead, it depends on FFCB to issue and market debt securities to finance lending capabilities. The Farm Credit System provides more than one third of the credit needed by those who live and work in rural America. The FFCB is a cooperative structure, with four banks: AgFirst FCB (NR/AA-/AA-), AgriBank (Aa3/AA-/AA-), FCB of Texas (Aa3/NR/AA-), and CoBank ACB (NR/AA-/AA-). All institutions in the Farm Credit System, including the FFCB, are examined and regulated by the Farm Credit Administration. The Farm Credit System Insurance Corp. ensures the timely payment of principal and interest on insured notes, bonds, and other obligations issued on behalf of FFCB to the extent that funds are available. As of most recent filings, FFCB had $208B in total debt outstanding. Federal Agricultural Mortgage Corp. ( Farmer Mac ) Not Rated Distinct and separate from the Farm Credit System, Farmer Mac is a stockholder-owned, GSE chartered by Congress in 1988 to improve the availability of long-term credit for farmers, ranchers, rural utilities, businesses, and communities in the US. It provides a secondary market for farm mortgages originated by commercial banks and other lenders. While separate from Farm Credit, Farmer Mac is regulated by the Farm Credit Administration. The GSE issues its own notes and bonds to fund its operations, and its debt is not rated. In 2008, the Farm Credit System s banks bailed out Farmer Mac with $60MM in capital. Farmer Mac debt trades at wider spreads versus other similar agency debt as a result of not having credit ratings. As of most recent filings, Farmer Mac had $12B in total debt outstanding. Each Agency s Share of Total Debt Outstanding TVA 1% Farmer Mac 1% During the recession, the FHLB increased its secured loans to members outstanding to more than $1 trillion, while all other sources of funding dried up. FMCC 25% FFCB 10% FHLB 37% FNMA 26% Source: Janney FISR; SIFMA; as of 4Q 2013 Agency bonds Page 4 Tennessee Valley Authority ( TVA ) Aaa/AA+/NR Chartered in 1933, TVA is a government corporation and the largest public power system in the US, supplying power to over 9MM residents of TN, AL, MS, KY, GE, NC, and VA. Electricity sales account for all of TVA s revenues, and more specifically, sales to municipalities and cooperatives make up 85% of the total. TVA is subject to Congressional oversight; therefore, Congress can choose to expand or reduce TVA s activities, change TVA s structure, or eliminate TVA completely. The TVA Act restricts the total debt TVA can have outstanding to $30.0B (not including lease financings). It is self-funded and the agency s bonds are not guaranteed by the US government, but rather backed solely by the net power proceeds of the TVA power system. (Recent debate over TVA s debt has
5 built up from the Obama Administration s exploration of strategic alternatives for the agency in its FY2014 Budget.) Interest on TVA securities are generally exempt from state and local taxes, but not from federal income tax. As of most recent filings, TVA had $26B in total debt outstanding. Other Issuers Resolution Funding Corp. (REFCO) and Financing Corp. (FICO) no longer issue debt, but currently have outstanding issuances. These agencies were created in the 1980s as funding mechanisms for resolution of the Savings and Loan crisis. Many of the bonds issued by these agencies have been remarketed as zero coupon bonds. Like Ginnie Mae, Federal Housing Administration (FHA) and Small Business Administration (SBA) bonds are backed by the full faith and credit of the US government. The FHA was established in 1934, and insures home-building related loans originated by banks and other financial institutions. The SBA was created in 1953 to provide liquidity to the commercial loan market, decreasing the cost and improving availability of financing for small businesses. The SBA guarantees a portion of small business loans originated by commercial banks. The banks can then securitize a portion of these loans and pool them into asset-backed securities under the SBA label in three separate programs. Conclusion Recent debate over TVA s debt has built up from the Obama Administration s exploration of strategic alternatives for the agency in its FY2014 Budget. The agency market is one of the most liquid markets globally. The largest issuers make up most of the market. Agencies offer various types of bonds, including callable bonds, bullets, floating rate notes, zero coupon bonds, and mortgage-backed securities. The high ratings of most agency debt outstanding combined with a yield pick-up over Treasuries attracts various types of investors looking to diversify their investment strategies and portfolios. Agency bonds Page 5
6 Analyst Certification I, Jody Lurie, the Primarily Responsible Analyst for this report, hereby certify that all of the views expressed in this report accurately reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Janney Montgomery Scott LLC ( Janney ) Debt Research Disclosure Legend Janney may seek compensation for investment banking services for any company listed in this report in the next 3 months. The research analyst is compensated based on, in part, Janney s profitability, which includes its investment banking revenues. Additional information available upon request. Definition of Issuer/Company Outlooks Janney FIS employs a rating system which considers the company, but not any specific debt or equity securities of the company and is not making a recommendation with regard to any specific debt securities of the company. Outlooks reflect our opinion about how credit factors of the company may affect its credit rating(s). Positive: Janney FIS believes there are factors which point towards improving issuer or sector credit quality which may result in potential credit ratings upgrades Stable: Janney FIS believes there are factors which point towards stable issuer or sector credit quality which are unlikely to result in either potential credit ratings upgrades or downgrades. Cautious: Janney FIS believes there are factors which introduce the potential for declines in issuer or sector credit quality that may result in potential credit ratings downgrades. Negative: Janney FIS believes there are factors which point towards weakening in issuer credit quality that will likely result in credit ratings downgrades. Definition of Sector/Industry Ratings Overweight: Janney FIS expects the target asset class or sector to outperform the comparable benchmark (below) in its asset class in terms of total return. Marketweight: Janney FIS expects the target asset class or sector to perform in line with the comparable benchmark (below) in its asset class in terms of total return. Underweight: Janney FIS expects the target asset class or sector to underperform the comparable benchmark (below) in its asset class in terms of total return. Janney FIS Outlooks Distribution as of 02/05/2014 IB Serv./Past 12 Mos. Outlook Count Percent Count Percent Positive Stable Cautious Negative Benchmarks Asset Classes: Janney FIS ratings for domestic fixed income asset classes including Treasuries, Agencies, Mortgages, Investment Grade Credit, High Yield Credit, and Municipals employ the Barclay s U.S. Aggregate Bond Market Index as a benchmark. Treasuries: Janney FIS ratings employ the Barclay s U.S. Treasury Index as a benchmark. Agencies: Janney FIS ratings employ the Barclay s U.S. Agency Index as a benchmark. Mortgages: Janney FIS ratings employ the Barclay s U.S. MBS Index as a benchmark. Investment Grade Credit: Janney FIS ratings employ the Barclay s U.S. Credit Index as a benchmark. High Yield Credit: Janney FIS ratings for employ Barclay s U.S. Corporate High Yield Index as a benchmark. Municipals: Janney FIS ratings employ the Barclay s Municipal Bond Index as a benchmark. Disclaimer Janney or its affiliates may from time to time have a proprietary position in the various debt obligations of the issuers mentioned in this publication. Unless otherwise noted, market data is from Bloomberg, Barclays, and Janney Fixed Income Strategy & Research (Janney FIS). This report is the intellectual property of Janney Montgomery Scott LLC (Janney) and may not be reproduced, distributed, or published by any person for any purpose without Janney s express prior written consent. This report has been prepared by Janney and is to be used for informational purposes only. In no event should it be construed as a solicitation or offer to purchase or sell a security. The information presented herein is taken from sources believed to be reliable, but is not guaranteed by Janney as to accuracy or completeness. Any issue named or rates mentioned are used for illustrative purposes only, and may not represent the specific features or securities available at a given time. Preliminary Official Statements, Final Official Statements, or Prospectuses for any new issues mentioned herein are available upon request. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, securities prices, market indexes, as well as operational or financial conditions of issuers or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. We have no obligation to tell you when opinions or information contained in Janney FIS publications change. Janney Fixed Income Strategy does not provide individually tailored investment advice and this document has been prepared without regard to the circumstances and objectives of those who receive it. The appropriateness of an investment or strategy will depend on an investor s circumstances and objectives. For investment advice specific to your individual situation, or for additional information on this or other topics, please contact your Janney Financial Consultant and/or your tax or legal advisor. Agency bonds Page 6