There was a time when it was easy to outshine a Treasury investment with little risk. Federal agency debt was the key.  That time is long gone, a consequence of the financial crisis and the Great Recession of 2008.  The result diminished, perhaps forever, the role of federal agencies that had been a lynchpin of public sector portfolios before the financial crisis.

States and localities have responded by boosting Treasury holdings or by expanding their investment parameters into the corporate credit space. Commercial paper, negotiable bank deposits and corporate bonds are now a significant part of the portfolios of many states and localities, and prime-oriented local government investment pools have experienced strong asset growth, perhaps because the “safe” alternative of investing in federal agency securities no longer produces significant incremental income.

Before the Fall

Federal agency debt, led by issuances of Fannie Mae and Freddie Mac, was plentiful, liquid, virtually risk free and—by today’s standards—cheap. If you wanted to boost your investment income, you could buy a Fannie Mae discount note or short-term bond and pick up as much as 30-50  basis points of yield. The accompanying chart compares yields today with those available at the end of 2007, before the Great Recession. Today Fannie Mae will pay you less than 10 basis points more than same maturity Treasuries, and maybe as little as two or three basis points--or zero--for your money. The same goes for the other Federal agency issuers, Freddie Mac, the FHL Banks, the Farm Credit System, Farmer Mac and the Tennessee Valley Authority.

Federal Agency Issuance Has Not Kept Pace With the Market

The total outstanding debt of the Federal agencies last year was about $2 trillion, roughly equal to that in 2007, but the character has changed.

In 2007, Fannie Mae had $1 trillion outstanding debt. Outstandings at the end of 2024 totaled $143 billion. The story was similar with Freddie Mac. It had $751 billion outstanding in 2007, and $188 billion at the end of last year.

The mix has also changed. Last year just under 20% of the outstanding debt of these agencies matured in less than one year. Ten years ago, it represented 31% of the overall debt outstanding. Before the financial crisis Fannie Mae concentrated 45-50% of its issuance in short-term discount notes.

For scale, consider that Treasury bills outstanding in 2007 were just under $1 trillion(!) compared with $6.2 trillion at the end of 2024. So, by today’s measure short term Treasuries were scarce while the nearly-as-safe federal agency debt was plentiful. The federal agencies paid up for this (agency debt offered yields higher by 30 basis points or more than Treasuries), ultimately to the detriment of the taxpayers when they became insolvent, but investors in search of incremental yields were easily satisfied with issuances from these giant government sponsored enterprises.

Fast forward 15 years and a lot has changed. The total volume of GSE debt outstanding is about the same, but Fannie Mae and Freddie Mac are smaller players. The space is dominated now by the FHL Banks, which ended the year with $1.2 trillion outstanding. That’s nearly 60% of the total for all agencies.  

Fannie Mae, Freddie Mac and the FHL Banks were originally created to support the housing market. They grew to such size with so much financial leverage that eventually Fannie and Freddie failed, requiring a bail-out by US, and they have been in conservatorship ever since.

And the housing market? Well, by most measures it is in much worse condition today than 20 years ago when they peaked at two million units a year. Last year they totaled 1.5 million on a much larger population base.

But That’s Not the Point

Public sector portfolio strategies have morphed from the “easy button” days when it took few resources and not a lot of sophistication to add value to a portfolio by buying “risk free” agency obligations. Credit and risk management were straightforward because, truth be told, government sponsored enterprises were essential to the financial system, and we always believed that they would not be allowed to fail.

Discount notes and non-callable agency notes were analogous to Treasury bills and Treasury Notes, so it did not take much analytic power to identify value-added—by comparing yields. And more complex federal agency issuances, including callable notes and mortgage-backed securities, were not a major product or (in the case of mortgage-backed securities) not widely held by public sector investors.

Today, if you are a public sector investor seeking value beyond that offered by Treasuries, you’re compelled to look at more complex structures of GSE debt or to accept the credit risk that goes with corporate bonds.

State laws and investment policies have changed to expand access to credit instruments, but with this expansion has come an appropriate (!) focus on credit, because corporations—even those rated AAA—can and do default on their debts. It’s fair to say that many public sector portfolios today have greater credit risk when compared with those before the financial crisis.

Some public agencies have responded  to this change by staffing up internal capacity to assess  credit, but the reality is that a robust credit team and process—the resources that support an insurance company, bank or specialized investment fund investing in credit—are likely well beyond the means of a public unit. 

Public agencies may restrict credit investments to a portion of their portfolios and limit maturity. Both can be effective at managing risk, but they do not eliminate it.

Some states and local governments have hired an investment advisor, in effect outsourcing credit and risk management. This is not without cost, but the expectation is that greater investment returns will more than offset the costs. You could think of prime LGIPs in the same way: credit management is outsourced, with some prime LGIPs investing almost 100% of their assets in credit instruments.

Federal Agencies Remain Important for Public Sector Investors

Nonetheless federal agency debt remains a significant component of public sector investment assets, particularly for internally managed portfolios and those investors who do not want to take any credit risk. The Federal Reserve’s Financial Accounts report for the third quarter of 2024 showed about 12%, or nearly $500 billion of public funds investments are in Federal agency obligations.

Public sector holdings represent about 25% of the total outstanding Federal agency debt (about $2 trillion at the end of last year) making these issuers highly dependent on public sector investment flows.

Concentration in debt of the FHL Banks has grown markedly. This means portfolio holdings are more likely to be concentrated. If you accept the premise that FHL Banks are so essential to the plumbing of the financial system they will not be allowed to fail, this concentration in and of itself may not be bad. It has led some public agencies to adjust investment policy limitations on concentration to accommodate today’s reality.

Meanwhile the types of notes issued by the GSEs have changed as Freddie Mac and Fannie Mae now favor callable securities. Before their insolvency, these agencies largely managed the mismatch between their (callable) mortgage holdings and noncallable debt internally, using derivatives. Now they have passed much of this risk to investors by increasing the use of callable debt. For Freddie Mac, at the end of last year two-thirds of its debt due in more than one year is callable. This compares with 46% before its insolvency.

Callable securities may offer higher nominal yields than those that are non-callable, but they are not well-suited for cash flow management and their total returns may disappoint investors. As the accompanying chart shows, an index of callable GSE debt underperformed non-callables over the past three and five years and also underperformed Treasuries over the longer time frame. Individual callable notes may—or may not—produce value when compared with Treasuries. Determining their value (and risk) is challenging, both because the mathematics is complex ( solved easily if one has a Bloomberg terminal) and because the assumptions about the future path of rates and rate volatility are variable.

In short, portfolios with these securities have heightened market risk.

Oh, for the good old days when adding value to a risk-adverse portfolio weas straightforward!