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 collateralized debt obligations (CDOs), mortgage-backed securities, and credit default swaps (CDS).
Understanding the Credit Market
The credit market dwarfs the equity market in terms of dollar value. As such, the state of the credit market acts as an indicator of the relative health of the markets and economy 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.
When corporations, national governments, and municipalities need to earn money, they issue bonds. Investors who buy the bonds essentially loan the issuer money. In turn, the issuer pays 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 prior to maturity.
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. As payments are received on the bundled debt, the buyer earns interest on the security, but if too many borrowers (in the bundled pool) default on their loans, the buyer loses.
- The credit market is where investors and institutions can buy debt securities such as bonds.
- Issuing debt securities is how governments and corporations raise capital, taking investors money now and paying interest until they pay back the debt at maturity.
- The credit market is larger than the equity market, so traders look for strength or weakness in the credit market to signal strength or weakness in the economy.
The 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 as investors are viewing corporate bonds as increasingly risky.
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 she buys a stock, she 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
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 risk exposure related to any single security, some investors invest in bond funds and exchange traded funds (ETF) that consist of a group of bonds.
Credit Market Participants
Corporations also issue corporate bonds, which make up the second largest portion of the credit market. Through corporate bonds, investors lend corporations money they can use to expand their business. In return, the company pays the holder an interest fee and repays the principal at the end of the term.
Municipalities and government agencies may issue bonds. These may help fund a city housing project, for example.
Credit Market Example
In 2017, Apple Inc (AAPL) issued $1 billion in bonds that mature in 2027. The bonds pay a coupon of 3%, with payments twice per year. The bond has a $1000 face value, payable at maturity.
An investor looking to receive steady income could buy the bonds, assuming they believe Apple will be able to afford the interest payments through to 2027 and pay the face value at maturity. At the time of the issue, Apple had a high credit rating.
The investor can buy and sell the bonds at any time, as it is not required to hold the bond until maturity.
For the year between April 2018 and April 2019, the bonds had a range of 92.69 to 99.90. This means that the bondholder could have received the coupon but also seen their bond value increase if they bought at the lower end of the range. People buying near the top of the range would have seen their bonds fall in value but would have still received the coupon.
Bond prices rise and fall due to company-related risk, but mainly because of changes in interest rates in the economy. If interest rates rise, the lower fixed coupon becomes less attractive and the bond price falls. If interest rates decline, the higher fixed coupon becomes more attractive and the bond price rises.