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credit market

What is the credit market?

The credit market is a financial market where the government and companies issue debt to investors to raise money. Here, the investors buy and sell securities, mostly in the form of bonds. Also, in a developing market like India, these markets are an important source of funds. Moreover, the market size of the Indian credit market is one of the largest in Asia. Furthermore, like other countries, the credit market in India is also a substitute for banking channels for finance. Hence, the Credit market is also known as the Debt Market. 

The debt issued in the credit market can be in the form of junk bonds, government bonds, investment-grade bonds and commercial paper. Also, it includes debt offerings such as notes and securitized obligations, collateralized debt obligations (CDOs), credit default swaps (CDS) and mortgage-backed securities.

The status of the credit markets depicts the collective health of the economy. Comparatively, the credit market is larger than the equity market. Hence, traders look for strength or weakness in the credit market. Thus, this acts as a signal to understand the same effect on the economy. 

This market plays a vital role in the Indian economy to meet the financial needs in the various segments. The following are the regulators of the credit market in India –

Understanding the credit market

The credit market is a market for trading (buying and selling) fixed income instruments. Usually, the fixed income instruments are issued by central and state governments, government bodies and municipal corporations. Also, private entities like banks, financial institutions, corporates etc. can issue fixed income instruments. 

In other words, bond or debt can be defined as a loan in which the investor is a lender. Investors buy bonds from the issuer in exchange for money for a fixed tenure. Also, the issuer of the bond pays interest to the investors in return for the amount invested. Finally, upon maturity, the investor sells back the bond to the issuer at face value. Therefore, at the end of the term investor receives principal amount along with interest. Furthermore, there is a possibility that investors can sell bonds to another investor before maturity in the secondary market.

The most distinguishing feature of the credit market is that the fixed income instruments offer fixed returns. In other words, the returns are risk-free. Hence, this fixed return on the bond is known as ‘coupon rate’ or ‘interest rate’. Therefore, the buyer of the bond is giving a loan to the seller at a fixed rate known as the coupon rate. Also, the bond prices are inversely proportional to the interest rate. In other words, when the bond prices increase, the interest rate falls and vice-versa. 

There are also some other aspects to look at in the credit market. These consist of consumer debts like credit cards, mortgages, bank loans and car loans. However, these aspects become a bit complicated to deal with. 

Factors that affect the credit market

The following are the factors that affect the credit market internally and externally.

Internal factors

  • RBI economic policies
  • Liquidity in the market
  • Interest rate movement 
  • Inflation rate
  • Demand for money
  • Supply of money
  • Government borrowings to tide over its fiscal deficit
  • The credit quality of the issuer

External Factors

  • Global economic conditions and their impact
  • Foreign exchange
  • Fed rates
  • Crude oil prices
  • Economic indicators

Above all, the primary indicators for the health of the credit market are – prevailing interest rates and investors demand. Therefore, one must analyse and study the spread between the interest rates on bonds. For instance, bonds like treasury bonds and corporate bonds or investment-grade bonds or junk bonds. 

Usually, the treasury bonds offer the lowest interest rates in comparison to other bonds. Hence, there is the lowest default risk associated with treasury bonds. Comparatively, corporate bonds have higher interest rates and are riskier by default. Therefore, as an investor, it is essential to understand the spread between the interest rates of these bonds. When the spread between the bonds widens, i.e. government bonds are in favour over corporate bonds, Accordingly, this is a signal for the economy. Meanwhile, analysts expect that the economy is entering a recession where corporate bonds are riskier. 

Types

The credit market can be classified into two categories – 

Government Securities Market

This is one of the significant sources of borrowing funds by the central and state governments. The government issues short term and long term securities to raise funds from the general public. However, these securities do not carry any risk. The reason being, the government promises the payment of interest and repayment of the principal amount. These securities are also known as gilt-edged securities. Thus, the government securities market is the major market in any economic system. 

Corporate Bond Market

The corporate bond market is a similar financial market where the private and public corporations issue bonds and debt securities. Likewise, the companies issue bonds to raise money for a variety of purposes. For instance, building a plant, purchasing equipment or business expansion. When these bonds are sold to the investors, the company gets its capital required. In return, the company pays a pre-established number of interest payments at either a fixed or variable interest rate. Lastly, on the maturity of the bond, the issuer pays the principal and interest to the investor.

Generally, the bonds are issued first in the primary market as a ‘new issue’. Here, the issuers sell the bond to investors to raise capital. Sometimes the investors might also sell the bonds to the existing investors, which is the secondary market. Thus, investors can buy and sell existing securities. 

Usually, corporate bonds are riskier than government bonds. Hence, they carry additional risk and offer higher interest rates. Also, the highest quality bonds are termed as ‘Triple-A’(AAA) rated bonds while the least creditworthy bonds are referred to as junk bonds. Therefore, investors should check the credit quality of these bonds before investing. 

Equity market vs credit market

The following are the differences between the equity market and credit market.

FeatureEquity MarketCredit Market
MeaningInvestment in equity market indicates the ownership of the buyer in the issuing company.Investment in the credit market only indicates the financial interest of the buyer. Here the individual does not get ownership rights.
Investment instrumentInvestors invest in the stocks of the companies listed on the stock exchange.Investors invest in debt securities issued by government or corporates.
OwnershipEquities are owned capital.Debt is a form of borrowed capital.
Who can issueCompanies registered with SEBIGovernment, companies
RegulatorsThe equity market is regulated and monitored by SEBI.In the credit market where the highly rated companies issue debt instruments which are regulated by SEBI. Whereas, the g-secs are issued by financial institutions and banks which are regulated by RBI.
ReturnsInvestors invest in the stock market with a hope to earn more returns with rising market volatility.The credit market is mainly for investors with low-risk tolerance. Thus, they offer lower returns to investors. 
Raising moneyThe equity market allows companies to raise money without incurring debt.The credit market allows entities to raise money by incurring debt through issuing debt instruments.
Investor statusThe investors become the shareholders of the company, who are part owners.The investors/bondholders become the creditors to the company or government(issuing company)
RiskInvesting in the stock market, an investor might lose money due to market volatility.Investing in the credit market, the chances to lose money is lower as government bonds are risk-free investments. However, corporate bonds have default risk associated with them as the company might default the payment. 

From the above analysis, it is clear that the stock market (equity market) and credit market are two different asset classes for the investors. Thus, Investors who are looking for capital appreciation through risk exposure can invest in equity markets. On the other hand, the credit market is suitable for investors who are looking for capital appreciation with less volatile investment instruments. Also, in the credit market, corporate bonds are riskier than government bonds. 

Therefore, an investor can invest in both the equity market and credit market at the same time. However, one must diversify its portfolio and balance their overall investment risk. Furthermore, based on the financial goals and risk profile capital can be allocated towards the asset classes for optimal diversification. 

Who are the market participants in the credit market?

The following are the market participants in credit market.

  • Banks
  • Financial institutions
  • Primary dealers
  • Insurance companies
  • Provident funds
  • Mutual fund houses
  • Corporates
  • Foreign institutional investors (FIIs)
  • Trusts

Frequently Asked Questions

What is a municipal bond?

The municipal bond market is a part of the credit market. Generally, these bonds are issued by urban local bodies to fund projects like building roads, bridges and schools. Also, the interest of these bonds is paid to the investors through the returns generated by developed infrastructure. Moreover, several local bodies have issued municipal bonds in India. 

What are the different securities issued in the credit market?

The following are the different types of securities that are issued in the credit market.
1. Treasury bills
2. GOI savings bond
3. Sovereign gold bonds
4. Capital gain bonds
5. Cash management bills (CMBs)
6. Dated G-secs
7. State Development Loans (SDLs)
8. Money market instruments like certificates of deposits, commercial papers, etc.
9. Investors can also get exposure in the credit market through mutual fund investments.

Published on November 9, 2020