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Government-sponsored enterprise bonds can boost cash flow

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Sometimes the search for decent yields in a low-rate environment can lead to taking too much risk. Government-sponsored enterprises (GSEs) issue bonds that can provide some intriguing yields and yet they’re close to top-tier investments when it comes to safety.

GSEs are financial services corporations created by Congress to facilitate lending in certain key sectors of the economy such as housing and agriculture. Federal Home Loan Bank, Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), Federal Farm Credit Bank, and the Federal Agricultural Mortgage Corporation (Farmer Mac) are GSEs. These organizations have the implied backing of the federal government, which differs from the implicit backing carried by official government agencies such as the Government National Mortgage Association (Ginnie Mae).

GSEs issue bonds and, while they are not totally risk-free, none have defaulted and many people believe the government wouldn’t allow a default — but that’s a subject of some debate these days.

As you may have surmised from the names of these GSEs, they have not escaped unscathed by the mortgage crisis and credit crunch. The result is that their bonds are often sporting high coupons and are selling at low premiums.

Let’s look at a Federal Home Loan Bank bond recently offered on the secondary market; meaning this isn’t the first time the bond is up for sale.

Federal Home Loan Bank issued this bond with the right to recall it, or redeem it, before the maturity date. In this case, the maturity date is September 2009, but the bond can be called as early as September 2008.

How bonds are priced

New bonds are usually issued at par, or face value, which is $1,000 per bond. When a new bond is sold and then bought by someone else on the secondary market the value of the bond changes because interest rates have changed. The bond may still trade at par, but it often trades for more or less than $1,000 — it’s said to trade at a premium or a discount.

In our example, the bond is trading at a premium; its price is $1,006.60. Bond prices are based on 100, meaning 100 percent of par. When the price is listed as 100.66000, move the decimal point one place to the right to get the price you’ll pay.

As you can see, this bond is callable September 2008 at 100. That means, if the bond is called, you’ll receive $1,000 per bond, not the $1,006.60 you paid. You paid a premium because the bond’s coupon, 5.33 percent, is higher than what the benchmark investment, a Treasury bond, is paying. The coupon is the stated interest rate that’s set when the bond is issued. While the risk of default may be very slight, the fact that the bond can be called means you’re taking on reinvestment risk. The bond would likely be called if rates drop, and that means you could have a hard time finding another investment with a high return and as little risk.

Yield-to-worst is your return if you buy the bond now and it’s called at its next opportunity to be called, which is September 2008. Yield to maturity is your return if it’s not called and you’re able to hold the bond until the maturity date of September 2009. The main reason for the difference between yield-to-maturity and the coupon is the premium.

Jason Flurry, Certified Financial Planner and principal at Legacy Partners Financial Group in Woodstock, Ga., says these bonds can present a good opportunity.

“You can achieve a very attractive cash-flow rate for anywhere from a few months to a few years in the 5 percent to 6 percent range. Obviously, that’s a premium rate of return so you’re going to have to pay a premium price to get it, but the cost to buy these bonds is next to nothing. The reason it makes sense to look at these versus other options that are out there is because of the mortgage crisis and because they’re out of call protection. You don’t have much certainty that they’re going to be hanging around until maturity.”

While Flurry favors secondary-market bonds in this particular set of circumstances, another financial planner advises most individual investors to stick with new issues. “I’m not saying you shouldn’t buy (on the secondary market), but you have to know what you’re doing,” says Herb Hopwood, CFP and principal at Hopwood Financial Services in Great Falls, Va.

“If you’re buying a new issue, you’re buying at par. Worst-case scenario is it gets called in three to six months if you screwed up and bought one that was that short. But you’re going to get your money back and you got that decent interest rate all along,” he says. “If you bought something at par and a half, and it got called in three months, you could have something that looked like it was 5.5 percent and it becomes 3 percent real quickly. Always price these things off yield-to-worst; assume it will get called at the first call date at par.”

Figure worst-case scenario

Flurry agrees that yield-to-worst is an important number. He notes that investors need to shop around and compare yield-to-worst against current CD rates, for instance. In our example, the yield-to-worst is very low and that may be a reason to avoid it. If it had a similar coupon but a yield-to-worst in the 2.5 percent to 3 percent range, it may be worthwhile if the premium isn’t too steep. Ideally, your worst situation should be better than what you can get on the open market.

Flurry says this is for the person who wants some extra money to help with expenses, or for saving. “If yield is a consideration and safety is a number one concern, this is an alternative way to generate yield and cash flow. Instead of getting a CD for 3 percent down at the bank, they could get the same yield or better but the actual interest that comes in would be more in the 6 percent range.”

You can buy new or secondary issues of GSEs through institutions such as Fidelity, Vanguard and Schwab. Most have fairly extensive tutorials or will also assist you by phone. If you’d be more comfortable having a financial adviser handling these investments for you, try Bankrate’s directory of Certified Financial Planners.