What Is Full Faith And Credit?
Full faith and credit is a phrase used to describe the unconditional guarantee or commitment offered by an entity to back the interest and principal of another entity's debt. The full faith and credit commitment is typically employed by a government to help lower borrowing costs of a smaller, less stable government or of a government-sponsored agency.
- Full faith and credit is an unsecured method of backing debt based in trust and reputation.
- Governments offer issue bonds backed only by their ability to collect taxes and other revenues in the future.
- Because governments theoretically have the unlimited and lawful capacity to collect revenue, these bonds are often considered low-risk, and therefore carry lower yields.
Understanding Full Faith And Credit
The full faith and credit refers to the full borrowing power of a government which pledges to fulfill its payment obligations in a timely manner. The U.S. Treasury issues bills, notes, and bonds as a means of borrowing money from the public to fund the government’s capital projects. These securities require that interest payments be made to lenders and investors periodically. On the maturity date, bondholders expect a full repayment of the face value of the securities. To encourage investors to purchase the debt issues, the Treasuries are backed by the full faith and credit of the government, providing assurance to fixed income investors that the expected interest payments and principal repayments will be made regardless of the economic situation.
Because Treasury securities are backed by the full faith and credit of the government, they are referred to as risk-free securities. The government cannot default on its obligations as it has the power to print more money or increase taxes in order to repay its debt. In addition, the interest rate on these risk-free securities also act as the benchmark rate for other fixed income securities that have some level of risk. In effect, the interest rate applied to debt instruments with risk is the risk-free rate plus a premium determined by the riskiness of the bond.
Risk-averse investors looking for safe investment typically go for securities that are backed by the full faith and credit of the government. These securities offer lower yields than securities with risk in the markets. However, investors are willing to accept the low yield in return for capital preservation and expected interest income.
Debt issued by a smaller government entity, such as a municipality, may also have the full faith and credit of the issuer. General obligation (GO) municipal bonds are payable from the municipality’s general funds and are backed by the full faith and credit of the municipal issuer which may have the unlimited authority to tax residents to pay bondholders. On rare occasions, the federal government may step in to back a portion of the payment obligations of municipalities by its full faith and credit. For example, during the credit crisis in 2009, investors shied away from muni bonds. To encourage lenders to invest in these securities the government the U.S. Treasury subsidized 35% of interest payments to investors and municipal issuers through a bond program known as the Build America Bonds.
The government also has the power to back debt obligations of government-sponsored agencies by its full faith and credit. When this occurs, the agency takes on the backer's credit quality, in this case, the U.S. government. The Government National Mortgage Association (Ginnie Mae) is one example of a government agency that is backed by the full faith and credit of the U.S. government. Securities backed by Ginnie Mae mortgages have lower yields than other mortgage-backed securities (MBS) because they are assumed to carry less risk due to federal government’s backing.