Agency discount notes are short-term securities (with maturities of one year or less) issued by U.S. government-sponsored enterprises to raise operating capital. They’re similar to treasury bills in that they’re sold at a discount, mature at face value (par) and pay no coupon interest. The difference between the discounted purchase price and par value — known as accreted interest — is paid to you at maturity and is generally exempt from state and local taxes, providing a yield advantage over similar fully taxable securities.
Agency discount notes are the most common type of short-term debt issued by federal agencies, although there are other agency securities such as non-callable agency bonds, callable agency notes and agency "step-up" bonds. Though not legal obligations of the federal government, agency discount notes are considered "moral obligations" of the government and, as such, offer high credit quality as well as a yield advantage over comparable U.S. treasury securities.
Major Issuers of Agency Discount Notes
Federal National Mortgage Association (FNMA) or "Fannie Mae." Fannie Mae is a stockholder-owned, U.S. government-sponsored corporation established during The Depression to provide liquidity to mortgage-lending institutions. Today it provides funds to the mortgage market by purchasing home mortgage loans from local lenders.
Federal Home Loan Mortgage Corporate (FHLMC) or "Freddie Mac." Also a stockholder-owned, U.S. government-sponsored corporation, Freddie Mac was established to increase mortgage credit and help maintain an active secondary mortgage market.
Federal Home Loan Banks (FHLB). This agency oversees and lends funds to commercial and thrift member banks that, in turn, use these funds primarily to support their mortgage programs.
Federal Farm Credit Banks (FFCB). The Farm Credit System provides loans and other services to farmers, ranchers and their cooperatives.
Benefits of Agency Discount Notes
- High credit quality. As a "moral obligation" of the U.S. government, an agency security offers high credit quality that’s second only to that of U.S. treasuries, to help you meet your capital preservation needs.
- Attractive yields. Because they’re a "moral" rather than a direct obligation, agencies offer higher yields than treasuries of comparable maturities.
- A variety of short-term maturities. Agency discount notes are available with maturities ranging from a few days to one year. Maturities can therefore be matched to your cash flow requirement dates.
- Liquidity. The agency market is highly active, providing ready liquidity if you choose to sell your discount notes prior to maturity. Prices may be more or less than the original investment amount, depending on market conditions.
- State and local tax-free income. The interest generated by many agency discount notes is generally exempt from state and local taxes. This tax-exempt feature provides a yield advantage over similar fully taxable securities. (State and local regulations may vary, so check the rules in your home state.)
Writer Thaddeus Toal is an independent financial planner based in Annapolis, Md., and can be reached at (410) 349-4916 or by e-mail at [email protected]. You can also visit his Web site at www.toalfinancial.com.
This article doesn’t constitute tax or legal advice. Consult your tax or legal advisor before making any tax-related or legally related investment decisions. This article is published for general informational purposes and isn’t an offer or solicitation to sell or buy any securities or commodities. Any particular investment should be analyzed based on its terms and risks as they relate to your specific circumstances and objectives.
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