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Answer:
Dear
Timothy,
For
those who are unfamiliar with agency bonds, let's
do a brief 101 and then answer your specific question.
What
they are...
Federal
and state agencies periodically issue bonds to raise
money for their various projects. The three federal
mortgage associations are the best known of the agency
bonds -- Fannie Mae (the largest investor in home
mortgage loans in the U.S.), Freddie Mac and Ginnie
Mae. Income earned is fully taxable.
On
the other hand, the Federal Farm Credit Bank issues
debt, which is generally exempt from state and local
taxes. The same is true for the Federal Home Loan
Bank System debt. The Student Loan Marketing Association,
known as Sallie Mae, is another option. Its debt is
generally exempt from state and local income tax,
but is taxed in certain states, including Massachusetts,
Mississippi, Pennsylvania and Tennessee.
And,
speaking of Tennessee, the income from the Tennessee
Valley Authority agency bonds is typically exempt
from state and local taxes.
Their
yields & the safety issue...
You
asked about the safety factor. They rate second only
to U.S. Treasuries in terms of credit quality. The
government agency status implies a moral obligation
on the part of the U.S. government. All agency bonds
raise their funds under the supervision of the U.S.
Treasury Department.
The
yields on government agency bonds are higher than
on regular government bonds, such as Treasury bills,
notes and bonds and government savings bonds. That's
because, although they are government issued they
are not backed by the full faith and credit of the
U.S. Treasury, with the exception of debt issued by
Ginnie Mae. So they are safe but not as safe as an
EE Savings Bond or the 10-year Treasury note, for
example.
Par
value & maturity...
These
bonds come with a par value ranging from $1,000 to
$25,000, sometimes more. Their maturity periods range
from 30 days to 20 years.
The
tax question...
Income
from Ginnie Maes, Fannie Maes and Freddie Macs are
taxable at the federal, state and local levels. Many
other government agency bonds, however, are exempt
from state and local taxes, as noted above.
A
potential negative...
Many
of these bonds can be "called." That is, the issuer
can call in the bond at par (the original face value).
This is particularly a problem with "step-up" bonds,
which you mentioned. Step-up bonds have interest rates
that increase at predetermined dates.
A
positive scenario: If interest rates keep rising,
bonds are unlikely to be called.
A
negative scenario: If interest rates remain level
or fall, the issuer will take advantage of the call
factor and you'll have to turn in your bond. You'll
never collect at those high interest rate payments
you had planned on receiving. The issuer may then
decide to offer new bonds at the lower rate.
If
your bonds are called, you're also left with money
to invest. If you elect to invest it in bonds (or
bank CDs or money market funds), it will be at the
new lower rate.
Good
luck!
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