U.S. Government and Agency Securities: An Analysis of Yield Spreads and Performance

Abstract

The volume of securities issued by federally sponsored corporations or agencies has increased rapidly during the past decade. These securities are now the basis of a major bond market, and some investors use them as substitutes for government securities. However, throughout the decade agency securities have had higher yields to maturity and higher expected holding-period returns than comparable government securities so that they have apparently not been used as perfect substitutes for government securities by all investors during the period. This paper documents these persistent yield spreads and changes in these spreads. It also describes the spreads as a function of the relationship between the agency and government markets. However, analysis of ex post holding-period returns to agency and government securities over the same period generates a pattern that is different from expected returns in some significant ways and from the pattern of yield spreads. If an investor were indifferent between the risks associated with these sets of securities, and if any additional expected returns to the agency securities were more than adequate to compensate for any additional transaction costs associated with the agency securities, then he might have been better off owning the agency securities. However, because yield spreads and differential holding-period returns do not always coinThe U.S. agency bond market has grown rapidly during the past decade. However, agency securities remain imperfect substitutes for U.S. government securities. Persistent yield spreads between these markets, changes in these spreads, and holdingperiod returns are documented, analyzed, and described as functions of the relationship between the markets.