Explained: Interconnectedness of Credit Market

The Credit market is also known as the ‘Debt Market’ because the credit market includes various forms of debt. The Credit market is also referred to as the ‘bond market’, as the bond market also characterizes the dominant portion of the credit market.

The credit market can be mainly classified into two categories – the Government Securities Market and the Corporate Bonds market.

The Government Securities like treasury bills and bonds or dated securities are issued by the Government. The Government securities are safe investments with no risk or low risk by default. These securities can be traded in the secondary market.

An investor who buys a corporate bond is effectively lending money to the company in return for periodical interest payments. These bonds can be traded in the secondary market. Corporate bonds offer higher coupons of interest but they are riskier by default.

The credit market also includes various forms of debt offerings, like securitized obligations and notes, which include credit default swaps (CDS), mortgage-backed securities, and collateralized debt obligations (CDOs).

Securitized debt instruments are loan obligations that have been packaged and sold as securities. These are usually bundled together with other debt instruments that have similar credit ratings, reducing the buyer’s risk exposure should any one of those debts default. The collateralized debt obligation (CDO) is offered to institutional investors in tranches or discrete classes based on the credit risk attached to every CDO. The process moves the loans’ risk of default from the bank to the investors. A credit default swap (CDS) is a financial swap agreement under which the seller of the CDS will compensate the buyer in the event of a debt default or other credit event.

The credit market is interconnected with several internal and external factors such as;

Economic policies of the Central Bank of a country (RBI in India) influence interest rates in the economy – like interest rates for housing loans, business loans, and interest rates on savings accounts. Changes in interest rates influence people’s decisions to invest or consume.
Liquidity in the market: Liquidity in the Market refers to how quickly assets may be purchased and sold in a market, including the stock exchange of a nation or the real estate market of a city. In a relatively illiquid market, an asset must be discounted to sell quickly.
Impact on equity and bond market due to interest rate movement: Interest rates are one of the most significant economic indicators that may affect a portfolio. When interest rates move up in the financial market, fixed return bond yields go down, people shift their investments from bonds to the equity markets and equity markets tend to outperform by a bigger margin, and as bond yields go up equity markets tend to falter. Similarly, the equity markets move negatively with bond yields when the interest rate goes down. Thus, stock prices and bond prices tended to move in opposite directions on the movement of interest rates.
Inflation rate: Because money is used in virtually all economic transactions, it has a powerful effect on economic activity. As inflation in a country rises, the central banks increase the interest rates to gain control. Bond prices are inversely rated to interest rates. Inflation causes interest rates to rise, leading to a decrease in the value of existing bonds. During times of high inflation, bonds yielding fixed interest rates tend to be less attractive.
Fed Rates: When the US Fed brings down interest rates in the US it can lead to higher foreign investment in Indian markets as foreign investors find India more profitable than the US because the difference between the interest rates of India and the US widens. The influx of foreign money will boost Indian debt markets further and vice versa when rates are increased by the US Fed.

In addition to the above, the credit quality of the debt instruments issued by the corporates, Global economic conditions, crude oil prices, volatility in foreign exchange rates, etc., impact the health of the credit market.