T O R ’ S G E S U I V D N I E T N O A GSE DEBT SECURITIES Various debt instruments to meet investor needs. CONTENTS THE GSE DEBT MARKET: AN OVERVIEW The GSE Debt Market: An Overview 1 Investor Benefits GSE Issuers and Their Financing Needs 5 Government-sponsored enterprises (GSEs) are Investor Risks financing entities created by Congress to fund loans 6 to certain groups of borrowers such as homeown- Federal & Congressional Oversight of the GSEs ers, farmers and students. Through the creation of 7 GSEs, the government has sought to address vari- General Description of GSE Debt Securities ous public policy concerns regarding the ability of 7 members of these groups to borrow sufficient funds Fixed-Rate Securities at affordable rates. GSEs are also sometimes 8 referred to as federal agencies or federally spon- Floating-Rate Securities sored agencies. The reader should note, however, 11 that there are organizational differences among the Non-Dollar Programs and Structures GSEs although all are established with a public pur- 15 pose: Student Loan Marketing Association (Sallie Primary GSE Issuance Programs Mae), Federal National Mortgage Association 16 (Fannie Mae) and Federal Home Loan Mortgage Offering Documentation for GSE Corporation (Freddie Mac) are privately owned Structured Debt Securities corporations, while the Federal Home Loan Banks 16 and the Federal Farm Credit Banks are systems The Secondary Market for GSE Debt comprising regional banks. All GSE debt is spon- 17 sored but not guaranteed by the federal government, Regulatory Issues Relating to GSE-Issued whereas government agencies such as Government Structured Debt Securities National Mortgage Association (Ginnie Mae) are 18 divisions of the government whose securities are A Caution on Tax and Accounting Issues backed by the full faith and credit of the United States. 19 To conduct their lending business, GSEs have sig- Questions Investors Should Ask and nificant funding requirements. While many are Information Resources stockholder-owned companies that can raise equity 19 capital, most GSEs rely primarily on debt financing The Issuers: Who Are They and What Do They Do? to fund their day-to-day operations. Among the most 21 active issuers of debt securities are: Federal Home Glossary Loan Banks, Freddie Mac, Fannie Mae, Federal 23 Farm Credit Banks, Sallie Mae and Tennessee Valley Authority (TVA). Supranational and interna- All information and opinions contained in this publication were produced by The tional institutions, such as the World Bank, also Bond Market Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, The issue debt securities. Complete descriptions of each Bond Market Association makes neither a recommendation as to the appropriate- GSE are provided beginning on page 21. ness of investing in fixed-income securities nor is it providing any specific invest- ment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions. 1 Buyers of GSE-issued debt securities include domes- corporate structures, the separate funding calendars tic and international banks, pension funds, mutual will vary as to specified issuance details. funds, hedge funds, insurance companies, founda- In 1997, the Federal Home Loan Banks Office of tions, other corporations, state and local govern- Finance began using auctions in its issuance of short- ments, foreign central banks, institutional investors term discount notes. Since then Freddie Mac and and individual investors. Fannie Mae have also incorporated auction formats The Credit Quality of GSEs in their programmatic short-term funding. In general, debt securities issued by GSEs are con- Additionally, all the GSEs post daily rates for dis- sidered to be of high credit quality. The senior debt count notes. Currently, most of the non-callable term of the GSEs is rated AAA/Aaa, while the subordinat- debt that is issued is in the form of conventional ed debt of Fannie Mae and Freddie Mac is currently notes having maturities of one, two, three, five, ten rated AA-/Aa-. Some GSEs have explicit, though lim- and thirty years. However, many GSEs have incorpo- ited, lines of credit from the U.S. Treasury. As a rated floating-rate and callable securities into their group, GSEs benefit from a perceived tie to the fed- issuance programs and regularly issue these struc- eral government as institutions established under tures as well. federal legislation. Today, GSEs increasingly choose to raise funds However, debt securities issued by GSEs are solely the through a variety of formal debt issuance programs. obligation of their issuer and, unless explicitly stated, Freddie Mac ‘Reference Notes™’, ‘Reference do not carry any guarantee by the federal government. Bonds™’ and ‘Reference Bills™’; Fannie Mae They are considered to carry greater credit risk than ‘Benchmark Notes™’, ‘Benchmark Bonds™’ and securities issued by the U.S. Treasury and certain ‘Benchmark Bills™’; Federal Home Loan Bank ‘TAP government agencies (e.g., Ginnie Mae) whose Issues™’; and Federal Farm Credit Bank ‘Designated securities have the full-faith-and-credit guarantee of Bonds™’ and Calendar Bond Program™ have all the U.S. government. For this reason, GSE debt been developed recently to brand these particular obligations often carry a yield premium over securities with certain attributes of liquidity and pric- Treasury securities with comparable maturities. The ing transparency. Several factors have contributed to premium varies with market volatility, and the struc- this recent change in the GSE debt market: ture, maturity, and general supply and demand for 1) Continued strong demand in the domestic the particular security. housing and agricultural markets The Growing Use of Regular Issuance 2) The development of a successful futures mar- Programs & Auctions ket in certain GSE debt The GSEs utilize a variety of issuance formats for their securities. Most long-term debt is issued in 3) A reduction in the issuance of debt by the U.S. public monthly security sales through designated Treasury and other governments and the dealer groups using both syndicate and auction pric- increase in investor demand for GSE debt ing methodologies. Currently, the majority of GSE 4) The broad availability of systems that provide term debt is issued through various programmatic enhanced fixed-income analytic capabilities issuance formats, as outlined in greater detail below. All the GSEs have created issuance programs that 5) New funding efficiencies offered by Internet incorporate funding calendars for large-size issues. technology and the development of hedging Due to differences in the GSEs’ organizational and markets. 2 3 The selective application of auction methodology in the issuer the option to call a bond or note, but if debt issuance by the GSEs in the last few years has interest rates decline the issuer might ultimately introduced greater regularity and transparency to the save money by exercising the call option. securities pricing process and made possible for the In connection with these structures, issuers often first time a true “when issued” (WI) market in those enter into customized options and/or swap agree- short- and long-term issues which are scheduled to ments with a third party. The third party may be an be auctioned. Working through The Bond Market investment bank, a subsidiary of an investment bank, Association, the dealers and issuers have helped a swap dealer or another entity. Under these agree- establish commonly used trading guidelines that gov- ments, the issuer receives a cash flow needed to ful- ern WI trading in GSE auctioned issues of term debt fill the terms of the security offering while agreeing with a maturity of two years and longer. (See to pay its counterparty a rate that might better match “Practice Guidelines for When-Issued Trading in the incoming cash flow on its assets. The GSE issuer GSE Auctioned Securities,” www.bondmarkets.com/ assumes all counterparty credit risk; a default by the agrees/practice_guidelines_for_wi_trading.pdf.) issuer’s counterparty on an option or swap agree- Additionally, advances in technology have enhanced ment does not change the issuer’s obligations to the market for customized interest rate swaps, options investors in the related security. and futures, and allowed the GSEs to issue a variety of structured products that can be highly tailored to INVESTOR BENEFITS simultaneously meet the very specific needs of issuers and investors. For instance, the GSEs have various medium-term-note (MTN) programs that allow them The variety of GSE-issued debt securities and pro- to come to market on a continuous basis with differ- grams offer investors a unique combination of high ent debt offerings. As a result, GSEs have gained the credit quality, liquidity, pricing transparency and flexibility to structure the size and terms of their debt cash flows that can be customized to closely match issues to meet the requirements of a particular an investor’s objective to: investor or class of investors. Under these programs, issuers may choose a variety of maturities with either • implement a current interest rate or currency callable or fixed maturities as well as floating interest view; rates, interest rates linked to one or more market • hedge a specific risk; indices, different interest payment dates and other • enhance portfolio liquidity: key features. The same flexibility can be achieved through individually negotiated security offerings. • balance portfolio performance characteristics; or The variety of issued securities enable GSEs to lower their cost of funding by targeting an issue to a • minimize transaction costs. particular investor need, since investors are typically The wide range of debt securities can be viewed as a willing to pay a premium to obtain a desired cash way of enabling investors to achieve the benefits flow or implement a particular market view.