Agency Bonds Look Very Attractive

I've stored a lot of my money in cash and money market funds over the last several years. With rates between 5 and 6%, this has been a solid way to preserve the money that I cannot afford to lose. I believe that rates may be about to decline sharply (a move could result from Thursday's decline in short-term Treasuries).

On Friday, I start to move my money into US agency bonds. Here's why:

Agency bonds trade at a premium over Treasuries because they are not backed by the US Full Faith and Credit. Most believe that in the event of a failure, the US government would bail out bondholders. Nevertheless, this is a risk that should be borne in mind and it is probably most prudent to divide your exposure between a handful of fagencies.

I buy agency bonds that are state and local tax exempt - such as Federal Home Loan Mortgage Association (FHLM), Federal Farm Credit Bank (FFCB) and Tennessee Valley Authority (TVA). Since I live in New York City, this is a measurable tax savings over comparable instruments.

On Friday, yields on these bonds should have fallen with the market. They didn't. I attribute this to a slightly widening risk premium, but more to the fact that everyone is scared and it is summer. Particularly, anything with the words home and mortgage in it isn't going to get a bid right now, even if it is a government agency. I should note that the calculated prices on agencies that I own, including FHLM, increased dramatically between Thursday and Friday.

The most interesting thing that I found on Friday were 12-year Federal Farm Credit Bank bond with a 6.40% coupon trading at par.

The risk in this bonds to me is not that of a default. The risk is that they are long term and I could get stuck holding bonds that are underwater if interest rates shoot higher (same risk as a long a Treasury). There is also a risk that the would be called in 1-year if interest rates go lower and the agency can refinance at a lower rate (they are callable and therefore will never appreciate in value the way that Treasuries might). In an environment where everyone seems to be losing their principal and with the likelihood of a continued decline in world markets, these are risks that I can take.