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Are government-backed agencies safe investments?

Should you invest in a government bond? See more investing pictures.
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Liesa Ownby needs a new ride. She is 19, balances college coursework with a part-time job and wants to borrow money to buy a used car. While Ownby feels like this is a feasible plan, local lenders see it differently. To them, Ownby isn't a safe investment. They worry that with her low pay and scant work history, she may default on her loan.

In a way, you face the same dilemma as an investor. When you buy stocks or bonds, you're actually loaning money. What guarantee do you have that you'll be paid back?

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That's where government backing comes in. In many cases, when you invest in a government-supported agency, you receive a payback guarantee. It's known as "full faith and credit" and refers to a government's promise to take responsibility for another entity's debt, should it default. This promise allows a government-backed agency to use a government's credit rating, which helps lower borrowing costs and attracts investors [source: Investopedia].

In Leisa Ownby's case, it would be like asking her father to co-sign a car loan. In doing so, Mr. Ownby would guarantee his daughter's debt, should she fail to make the payments. And, the lender could base the loan on Mr. Ownby's credit score to secure a lower interest rate.

As an investor, you may be wondering where you can find a Mr. Ownby of your own, at least when it comes to government-backed agencies. In the U.S., a government-backed agency bond refers to an entity that is part of the federal government, such as the Government National Mortgage Association (Ginnie Mae). Strictly speaking, Ginnie Mae does not issue bonds but insures mortgage-backed securities from other lenders. When you invest in these types of bonds, the government guarantees repayment [source: Fidelity].

Federally chartered corporations are another investment option, but are not backed by the full faith and credit of the U.S. government. Instead, they are backed by shareholders and are subject to some credit risk. Nevertheless, they are considered very safe due to their nature and offer a return rate somewhat higher than Ginnie Mae's. These government-sponsored enterprises (GSEs) include the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal Agricultural Mortgage Corporation (Farmer Mac) [sources: Morningstar, SIFMA].

Not all government-backed agencies offer the same investment protections, though. The Tennessee Valley Authority (TVA), for example, issues bonds backed not by shareholders, but backed instead by the agency's other revenue-generating projects [source: Fidelity].

You've worked hard, avoided flash sale sites and squirreled away a nest egg. It's time to put your money to work. Unfortunately, the idea of buying volatile stocks makes you break out in hives, which leads you to believe safe investments suit your financial style.

Fortunately, investing in government-backed agency or GSE bonds is typically a sure thing. Not only will your initial funds be returned when the bond matures, but you'll also be paid interest over the life of the bond. You'll need to be prepared to part ways with your money for months or years, though. Short-term bonds can take up to five years to mature; long-term bonds may require more than 20 years to mature. In general, the longer it takes a bond to ripen, the more money your investment will make over time. If you decide to cash in your bond before it matures, you could make or lose money depending on prevailing interest rates [source: Kansas].

The downside? While government-backed agency and GSE bonds are ideal for securing your funds, they won't make you rich. The safest assets usually yield the lowest returns. This is because they don't pose much of a risk; the better their credit rating, the lower the interest rate on your investment [source: Marquit, PIMCO]. In February 2013, for example, the interest rates on GSEs were hovering around 3 percent [source: Edward Jones].

Fortunately, understanding some of the tax benefits may assuage any regrets you harbor for failing to seek greater rewards in risky markets. Interest income from some GSE bonds, like those issued by Federal Farm Credit Banks Funding Corp., is exempt from state and local tax. Discovering whether your investment gains are tax-free requires some research; interest income from Fannie Mae, for example, is not state or local exempt. Keep in mind, too, that if you sell a bond before it matures, the profit will be subject to federal and state capital gains tax [source:Fidelity].

Author's Note: Are government-backed agencies safe investments?

I'm a budding investor. By budding, I mean I have a 401k, a couple of IRAs and a great desire to invest in something else. But just a little bit. And without the help of a broker. All of which makes the whole process even a little more daunting. I was especially interested to write this article because it could afford me the opportunity to learn more about investing in government-backed agencies. The safety of this proposition is intriguing, particularly if I were to invest a substantial sum. For less than $10 per online trade, though, I may just tackle a risk-laden learning curve on my own.

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Sources

  • Edward Jones. "Current Rates." Feb. 13, 2013. (Feb. 19, 2013) https://www.edwardjones.com/en_US/market/rates/current_rates/index.html
  • Fidelity. "Individual Bonds: Agency." (Feb. 16, 2013) https://www.fidelity.com/fixed-income-bonds/individual-bonds/agency-bonds
  • Goldfarb, Zachary. "S&P Downgrades U.S. Credit Rating for First Time." The Washington Post. Aug. 5, 2011. (Feb. 16, 2013). http://articles.washingtonpost.com/2011-08-05/business/35417342_1_downgrade-aaa-credit-ratings-government-debt
  • Investopedia. "Are Long-Term U.S. Government Investments Risk-Free?" (Feb. 16, 2013) http://www.investopedia.com/ask/answers/168.asp
  • Investopedia. "Full Faith and Credit." (Feb. 16, 2013) http://www.investopedia.com/terms/f/full-faith-credit.asp
  • Kansas, Dave. "What is a Bond?" (Feb. 16, 2013) http://guides.wsj.com/personal-finance/investing/what-is-a-bond/
  • Marquit, Miranda. "Why 'Safe' Investments Don't Make Your Rich." U.S. News and World Report. Sept. 17, 2012. (Feb. 16, 2013). http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2012/09/17/why-safe-investments-dont-make-you-rich
  • Morningstar. "U.S. Government Agency Bonds." (Feb. 19, 2013). http://news.morningstar.com/classroom2/course.asp?docId=5482&page=1&CN=sample
  • PIMCO. "Everything You Need to Know About Bonds." March 2012. (Feb. 16, 2013) http://www.pimco.com/en/education/pages/everythingyouneedtoknowaboutbonds.aspx
  • Securities Industry and Financial Markets Association. "Investing in Bonds." (Feb. 19, 2013). http://www.investinginbonds.com/learnmore.asp?catid=9&subcatid=94

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