An Introduction to Credit Markets

Capital markets can generally be divided into two components; the equity market and the credit market.

There are two types of categories: equity market and the credit market. The former provides the mechanism by which investors can trade a share of ownership in publicly traded companies, and thus exchange a legal claim in their future profitability, while the latter is a platform in which participants can issue new debt or trade existing debt instruments.

Although stocks and shares typically dominate the news and most retail investors’ focus, it is in fact the credit market where most of the action in capital markets takes place in.

Types of markets and participants

Although the bond and the credit market are terms often used interchangeably, the former is actually only a segment of the latter, which consists of any instrument used for an entity’s financing needs, including direct loans provided by a bank.

However, as bank loans don’t constitute securities and are therefore not regulated by the Securities and Exchanges Commission, the broader term has effectively come to refer to all issuance of debt in the capital markets.

The bond market itself can be further classified into several sub-categories, depending on the nature of the issuer of debt. The most prominent participants, on the issuing side, are arguably governmental agencies, public companies and municipalities, thus giving rise to the government, corporate and municipal bond markets, respectively.

Naturally, participants in the bond markets also include the buyers and sellers of the debt securities issued. These include large investment banks, hedge funds, institutional investors, as well as retail traders.

How does the Credit Market works ?

Simply put, the scope of the credit market is to provide the issuers of debt securities with funds to finance their future expenditures or to balance their current needs. A government, for instance, can issue a bond when it’s having difficulty to meet its current obligations due to a revenue shortfall, or in order to finance new public works.

Similarly, a company looking for a cheap way to raise money for its future expansion or acquisition plans, and wants at the same time to retain its present control of ownership, will choose the corporate bond market for the financing it requires.

Corporates predominantly use the process of underwriting when issuing bonds, which involves one or a syndicate of large investment banks buying the entire issue of bonds and then re-selling them to investors. Governments, on the other hand, tend to issue bonds through an auction process, in which a number of institutions bid for the bonds on offer, and thus determine their issuing price and corresponding interest rate.

The debt instruments are essentially a form of loan or IOU. The issuing entity receives funds from the investors for a fixed term and is under the obligation to pay a pre-agreed fixed or variable interest rate at set time intervals, as well as to repay the amount borrowed at a pre-determined date in the future, known as the bond maturity.

Once the bonds are issued, a process which is often referred to as the primary market, their prices will fluctuate depending on the prevailing market conditions, thus making further trading on them possible in what’s known as the secondary market.

What is Credit Market size and importance ?

The size of the global bond market is currently estimated to be close to $100 trillion, a figure which is more than twice that of the global equity market, as all types of issuers have rushed to take advantage of the prolonged environment of ultra-low interest rates globally.

Savvy investors thus keep a close eye on it, and often assign more weight on its moves than those in the equity markets; the first signs of investing trouble ahead will usually show up here.

The credit market’s size isn’t the only reason investors watch it closely, however. As it effectively determines the costs of borrowing, it serves as perhaps the best indication of business and economic conditions in the future.