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Narrator: When thinking about the credit worthiness of a bond, it's important to consider the issuer behind the bond. More specifically, it's important to understand how an issuer earns money to make interest payments and pay back the principal.
To help you understand this, let's examine the U.S. government. Consider a 10-year bond, or note, issued by the U.S. Treasury. Backing this 10-year note is the full faith and credit of the U.S. government and its ability to levy and collect taxes.
For the U.S. government, collecting taxes isn't much of an issue, and taxes are collected regardless of how the overall economy is doing—even if the total tax revenue dips during a recession. But beyond taxation, the U.S. government can borrow to pay its debt regardless of total tax revenues. This is helpful when the government operates at a deficit, which it has done for all but four years since 1970.
So, even in rough economic times, the U.S. government is more likely to be able to meet its obligations and pay interest on time and in full.
Now, let's compare this to a corporation. Suppose a corporation decides to issue a 10-year bond.
This 10-year bond is backed by the corporation's earnings and assets. But unlike the steady stream of money from taxes, a corporation's earnings and the value of its assets can change dramatically.
These changes might be due to swings in the broader economy, or they might be due to a new competitor entering the market.
In other words, a corporation has a higher credit risk. This is the risk that they could miss a coupon payment or not be able to return the principal to the investor.
Animation: A Treasury bond with a low credit risk and a corporate bond with a higher credit risk are compared.
Narrator: This is why investors and rating agencies typically perceive government bonds as less risky than corporate bonds.
The federal government isn't the only government that issues bonds; municipalities raise money through taxes too. However, cities have a much smaller tax base, and they don't have the same economic resources as the federal government when times get tough.
Animation: Three bonds are compared to include a Treasury bond with a low credit risk, a municipal bond with a moderate credit risk and a corporate bond with a high credit risk.
Narrator: There are many municipal bonds that are backed by financial resources other than tax revenues. Therefore, municipal bonds are perceived as riskier than government bonds.
But in the investing world, there's a trade-off between risk and return. The same applies to the world of bonds. Bonds issued by riskier entities tend to offer a higher yield, while bonds issued by safer entities tend to offer a lower yield.
Animation: A corporate bond and a Treasury bond are compared side by side. Both have a AAA rating and a 10-year maturity.
Narrator: For example, we could have two nearly identical bonds—both have the same credit rating and a 10-year maturity. The only difference is one is issued by a corporation and the other is issued by the U.S. Treasury. The corporate bond would likely offer a higher yield because a corporate bond carries more default risk.
Animation: A bond with a BBB- rating appears, which shows how the risk and return are the same.
Narrator: Issuers with lower credit worthiness usually offer higher interest rates to offset increased risks. And these differences in risk have a lot to do with the sources of money backing the issuers.
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