What is the 'Credit Market'
Credit market refers to the market through which companies and governments issue debt to investors, such as investment-grade bonds, junk bonds and short-term commercial paper. Sometimes called the debt market, the credit market also includes debt offerings, such as notes, and securitized obligations, including mortgage pools, collateralized debt obligations (CDOs), dwarfs and credit default swaps (CDS).
BREAKING DOWN 'Credit Market'The credit market dwarfs the equity market in terms of dollar value. As such, the current state of the credit market acts as an indicator of the relative health of the markets as a whole. Some analysts refer to the credit market as the canary in the mine, because the credit market typically shows signs of distress before the equity market.
How the Credit Market Works
When corporations, national governments and municipalities need to earn money, they issue bonds. Investors who buy the bonds essentially loan the issuers money. In turn, the issuers pay the investors interest on the bonds, and when the bonds mature, the investors sell them back to the issuers at face value. However, investors may also sell their bonds to other investors for more or less than their face values.
Other parts of the credit market are slightly more complicated, and they consist of consumer debt, such as mortgages, credit cards and car loans bundled together and sold as an investment. Simply, as the bank receives payments on the debt, the investor earns interest on his security, but if too many borrowers default on their loans, the investor loses.
Health of the Credit Market
Prevailing interest rates and investor demand are both indicators of the health of the credit market. Analysts also look at the spread between the interest rates on Treasury bonds and corporate bonds, including investment-grade bonds and junk bonds. Treasury bonds have the lowest default risk and, thus, the lowest interest rates, while corporate bonds have more default risk and higher interest rates. As the spread between the interest rates on those types of investments increases, it can foreshadow a recession.
Difference Between Credit and Equity Markets
While the credit market gives investors a chance to invest in corporate or consumer debt, the equity market gives investors a chance to invest in the equity of a company. For example, if an investor buys a bond from a company, he is lending the company money and investing in the credit market. If he buys a stock, he is investing in the equity of a company and essentially buying a share of its profits or assuming a share of its losses.
Why Investors Utilize the Credit Market
Simply, investors utilize the credit market in hopes of earning money. Bonds are considered to be safer investments than stocks, as they offer fixed-income earning potential, and if a company goes bankrupt, it pays its bondholders before its stockholders. To reduce their exposure of risk related to any single security, investors invest in mutual funds and exchange traded funds (ETF) that consist of a group of bonds.