Full Faith and Credit

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Full Faith and Credit

What Is Full Faith and Credit?

The term “full faith and credit” refers to one entity’s absolute promise or commitment to back the interest and principal of another entity’s debt. A government would often use the full confidence and credit promise to assist cut the borrowing costs of a smaller, less reliable government or a government-sponsored organization.

Key Takeaways

  • Full faith and credit is an unsecured debt-backing mechanism based on trust and reputation.
  • Governments issue bonds secured only by their capacity to collect future taxes and other revenues.
  • Because governments have an infinite and legal ability to collect money, these bonds are often seen as low-risk and so bear lower returns.
  • One example of a government institution backed by the full confidence and credit of the United States government is the Government National Mortgage Association (Ginnie Mae).

Understanding Full Faith and Credit

Full faith and credit refers to a government’s full borrowing authority that commits to meet its payment commitments on schedule. The United States Treasury produces bills, notes, and bonds to borrow money from the public to finance capital projects.

These securities need periodic interest payments to lenders and investors. Bondholders anticipate full repayment of the face value of the securities on the maturity date. To entice investors, Treasuries are backed by the government’s full faith and credit, assuring fixed income investors that the projected interest payments and principal repayments would be paid regardless of the economic circumstances.

Treasury securities are known as risk-free securities since they are guaranteed by the government’s complete faith and credit. The government cannot fail on its commitments because it has the authority to create additional money or raise taxes to cover its debt. Furthermore, the interest rate on these risk-free instruments serves as a benchmark rate for other fixed income products with some risk. In essence, the interest rate applied to risky debt instruments is the risk-free rate plus a premium defined by the bond’s riskiness.

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Risk-averse investors seeking secure investments often choose assets guaranteed by the government’s full faith and credit. These securities have lower yields than market-risk securities.

Investors are ready to accept lower yields on assets guaranteed by the government’s complete faith and credit in exchange for capital preservation and projected interest income.

Government Debts

Debt issued by a smaller government organization, such as a municipality, may also have the issuer’s full faith and credit. General obligation (GO) municipal bonds are due from the municipality’s general finances and are guaranteed by the municipal issuer’s full faith and credit, which may have limitless ability to tax inhabitants in order to pay bondholders.

On rare situations, the federal government may step in to support a part of a municipality’s payment commitments with its full faith and credit. During the 2009 financial crisis, for example, investors avoided municipal bonds. To encourage lenders to engage in these securities, the United States Treasury subsidized 35% of interest payments to investors and municipal issuers under the Build America Bonds bond program (BABs).

The government also has the authority to guarantee debt obligations of government-sponsored organizations with its full faith and credit. When this happens, the agency assumes the credit quality of the supporter, in this example, the United States government.

One example of a government institution backed by the full confidence and credit of the United States government is the Government National Mortgage Association (Ginnie Mae). Securities backed by Ginnie Mae mortgages offer lower yields than other mortgage-backed securities (MBS) since the federal government guarantees them.

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