Concept
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In the last video we mentioned that large governments have virtually no credit risk. One reason for this is that governments are much more well-established and stable entities than new businesses. In our example, the government has a wider and more diverse set of income sources with which to meet its obligations, as governments usually do. A second and more important reason is that governments have the unique ability to have their central bank print money that can be used to repay their debts. You may recall from Module 3 that borrowers are strongly incentivized to meet their obligations, if at all possible, so that lenders will agree to lend to them in the future. Although government defaults are possible, governments will usually resort to printing additional money, if necessary, so they can meet their debt obligations. A government default would signal a lack of credibility of the government. As a result, future borrowing will be expensive
and perhaps impossible for the government, in addition to other, far-reaching consequences for the economy.
For these reasons, government-issued bonds are often viewed as free of (or approximately free of) default risk. This makes them a useful point of comparison. If, for example, a government bond is trading at a price of 800, and a corporate bond (a bond issued by a company), with the same par value and maturity date, is trading at 750, the difference of 50 can be ascribed to default risk. If someone tried to sell their corporate bond for 800, no one would buy it — any rational, informed
investor would prefer to buy the government bond which is available at this same price. Instead, the market settles on a lower price, which can be seen as compensation to the investors for being vulnerable to the possible default of the company and therefore the default risk the investors face.
In the next video, we put this price comparison in terms of interest rates — here the 800 and 750 depend greatly on the par value and maturity date of these bonds. Therefore, the difference of 50 can only be interpreted in light of these additional details. Interest rates account for different sizes of par value and for the time until maturity. Hence, the difference between the two bonds’ interest rates is a more easily interpreted, more convenient way to express how the market perceives the default risk of the company.