| Bond type | Who issues it | Defining quirk | Default risk vs Treasuries |
|---|---|---|---|
| Agency MBS | Government-sponsored entities pooling residential mortgages (Fannie Mae, Freddie Mac, Ginnie Mae) | Prepayment risk — homeowners refinance when rates fall, returning principal early | Very low (Ginnie Mae explicitly US-backed; Fannie/Freddie implicitly backed) |
| Agency debt (non-MBS) | Federal agencies and GSEs issuing direct debt for their balance sheets | Not Treasury, but treated as nearly-Treasury by most investors | Very low (small premium over Treasuries reflects the 'implicit' nature of the backing) |
| General-obligation muni | State or local government, backed by tax revenue (the 'GO' moniker) | Interest is federally tax-free; often state-tax-free for in-state residents | Low for highly rated states; varies for cities and smaller issuers |
| Revenue muni | State/local entity, but backed by revenue from a SPECIFIC project (toll road, hospital, airport) | Default risk depends on the project's revenue, not the issuer's taxing power | Moderate — varies dramatically by project quality |
Tax-Equivalent Yield = Muni Yield / (1 - Marginal Tax Rate)
An MBS is a slice of a pool of home mortgages — usually thousands of them. When rates fall, homeowners refinance, paying off the old mortgages early. As an MBS holder, you wanted to keep collecting that 5% mortgage stream; instead, the principal comes back to you precisely when you would have to reinvest it at a lower rate. Conversely, when rates rise (and you would love to get your principal back to reinvest at higher rates), homeowners stop refinancing and you are stuck holding the old, low-rate mortgages longer. MBS pay slightly more than comparable Treasuries because investors require compensation for this asymmetry — they call it 'negative convexity,' but the mechanic is just: prepayments happen at the worst time for the bond holder.
Agency bonds (Fannie Mae, Freddie Mac, Federal Home Loan Bank, etc.) typically yield 5-25 bps more than comparable Treasuries — a small premium reflecting the 'implicit' nature of the federal backing. A BBB-rated corporate from a household-name company might also yield 100-200 bps over Treasuries. They feel similar (both are not Treasuries; both pay a small-ish premium), but the risk profile is very different. The agency premium reflects mostly liquidity and the absence of explicit Treasury status; the corporate premium reflects real default risk that varies with the business cycle. In a recession, corporate spreads can blow out 300-500 bps; agency spreads barely move. Do not lump them together because their yields look similar today.
Sit with the ideas.
Marisol is in the 35% federal tax bracket and lives in a state with no income tax. She is comparing a 4.0% AA-rated general-obligation muni from her state (federally tax-free) to a 5.5% A-rated corporate bond of similar duration. Both pay semi-annual coupons; both are held in her taxable brokerage account. Which is the better after-tax deal, and by how much?