What is the Credit market?
The largest financial market in the world, the credit market, allows governments and companies to finance themselves by issuing bonds and treasury bills. In terms of transaction volume, the credit market is the largest financial market in the world, far ahead of the foreign exchange market. It is the market in which the borrowers of capital and lenders meet, the latter being most often represented by states or companies. It includes the bank credit market as well as negotiable debt securities, bonds, but also government debts and loans to individuals.
The credit market is an integral part of the National Financial System, which also comprises the foreign exchange (currency), capital (securities), and money (government securities) markets. Its close link with economic growth gives its importance. The more developed, the better the allocation of resources in the economy. Organized by the banks, its purpose is to unite, through financial intermediation:
- Savers: Individuals who keep resources to protect themselves from unforeseen circumstances and form assets;
- Borrowers: Companies and governments with projects that bring productivity and development.
As credit drivers within the economy, these financial institutions grant and monitor their credit operations, since they take the risk when they lend.
What is the credit market?
The credit market is the set of debt markets, bringing together borrowers those who need capital and lenders individuals, banks, or financial institutions.
This includes bank credit, debt securities, bonds, and government debts. It is a very large market which knows many different operations by their nature and their size. The credit market is the largest financial market in the world, ahead of the foreign exchange and equity markets.
What is the relationship between the credit market and the capital market?
In the credit market, banking institutions are responsible for mapping risks and granting financing.
In the capital market, on the other hand, it is investment banks, brokers, and the stock exchange that provides a bridge between investors, who assess risks on their own, and companies and governments.
Both are impacted when the economic environment presents restrictions on credit, either through inadequate legislation or high regulatory costs. As a consequence, the cost of credit is higher and more concentrated in the banking sector.
What is the importance of positive registration for the credit market?
It is clear that, after the funding cost, default is the highest cost in the credit market. Until the appearance of the registration, banks only had information about agents who were already in default.
By including information on good payers, banks can better price the client's risk, leaving aside the average risk of the credit portfolio. This eliminates a problem that banks have always faced, called “adverse selection.” When the average interest rate is very high, it drives away good customers while subsidizing and attracting, at lower rates, customers with a higher risk of default.
A good indicator of market health
The credit market overshadows the equity market in terms of volume. Thus, the current state of the credit market is considered to be a very good indicator of the health of all the markets. For analysts, the credit market is nothing less than a canary in the mine: it often shows signs of weakness long before other financial markets, and therefore remains to be watched closely.
How the credit market works
When companies and governments need funds, they issue bonds. Investors who buy the bonds lend them money. In return, issuers pay interest to these investors, and when the bonds mature, investors resell them to the issuers at face value. The other facets of the credit market are much more complex and consist of consumer debt, credit card debt, and loans of all kinds, bundled together and sold as an investment. More simply, when the bank receives payment on the debt, investors earn interest on its securities. But if too many borrowers default on credit, then the investor loses their stake.
The health of the credit market
Current interest rates and investor demand are very good indicators of the health of the credit market. Analysts are also watching the spread between interest rates on treasury bills and corporate bonds, including premium bonds and junk stocks.
Treasury bills have the lowest risk of default and therefore offer the lowest interest rates, while corporate bonds have a higher default risk and higher interest rates.
If the spread between the interest rates of these two types of investment, analysts are worried about a recession.
Credit and equity markets
While the credit market gives investors the chance to invest in consumer and corporate debt, the equity market gives them the opportunity to invest in the capital of a company. If an investor buys a bond from a company, he lends money to that company while investing money in the credit market. If he buys a stock, he invests in the capital of a company and buys a share of its profits. But in this case, he will also suffer the consequences of the poor performance of this company.
Four types of credit market instruments
Based on the timing of their cash flows, we can distinguish four basic types of credit market instruments.
1. A simple loan in which the lender provides the borrower with a certain amount of funds, which must be repaid to him on the due date, with an additional interest payment.
2. A constant installment loan in which the creditor provides the borrower with some funds that must be repaid by returning periodically (for example, every month), for a certain number of years, the same amount is consisting of a share of principal and interest. For example, if you borrowed 1,000 dollars, you could be required to pay 126 dollars annually for 25 years with this tool. Installment loans, such as financing for car purchases and mortgage loans are often of the constant installment type.
In technical jargon, the amortization (repayment) of the loan through a constant installment is called amortization.
3. A coupon bond (or coupon bond) guarantees the owner the payment of a coupon every year up to the expiry date, when a certain final amount will be repaid, the nominal value, or par value.1The security has this name because once its bearer requested payment by detaching a coupon from the bond and sending it to the issuer, who then sent him the payment, this is no longer necessary today. For example, a coupon bond with a nominal value of 1,000 dollars could yield a coupon payment of 100 dollars a year for ten years and at the expiry date provided for the repayment of the par value of 1,000 dollars. Keep in mind that the face value of a bond is generally in multiples of 100.
A coupon obligation is identified by three pieces of information. The first is the company or entity that issued it, the second is its expiry date, while the third is the coupon rate or nominal rate, or the amount of the annual coupon payment expressed as a percentage of the nominal value obligation.
In our example, an annual coupon payment of 100 dollars is envisaged for a bond with a nominal value of 1,000 dollars: the coupon rate is therefore 100 / 1,000 = 0.10, i.e., 10%. Capital market instruments, such as BTPs (Multi-year Treasury Bills) and state and corporate bonds, are examples of coupon bonds.
4. Discount security (also known as a no-coupon or zero-coupon bond) is purchased at a price lower than its face value (with a discount); however, the repayment of the nominal value is expected upon expiry. Unlike a bonded coupon, the discounted security does not guarantee any interest payment, but only repays the nominal value. For example, discount security with a face value of 1,000 dollars could be purchased for 900 dollars; after one year, the holder will be reimbursed the nominal value of 1,000 dollars. BOTs (Treasury Bills) and long-term coupon-free securities are both examples of discounted securities.
These four types of instruments require payments at different times: for discounted securities, payment is expected only on the due date, while constant installment loans and coupon bonds involve periodic payments until maturity. How could you determine which of these tools gives you the best returns? They seem so different to you because the related payments take place at different times.
We will then analyze why interest rates vary according to the particular exogenous variables that are internal to the dynamics of supply and demand inherent in the financial instrument itself, for today, it's all Economist, analyst, and trader.
The credit market is a huge one, quite broad and diverse. Although some of its products are complex, it offers a lower-risk alternative to invest compared to other financial assets. By channeling the resources of saving investors to other economic agents that need to use resources, it also increases the efficiency of the economy as a whole. It serves as a “thermometer” of an economy's financial health and has a strong regulatory structure and bodies to ensure security for investors.
Author: Vicki Lezama