Credit Market Structure

What is Credit Market Structure?

The credit market is a significant source of financing for companies and governments worldwide and refers to the market where companies and governments issue varied types of debt instruments to raise money from investors.

The credit market (also known as the debt market) includes treasury bills, notes, and government bonds of varying maturities, investment-grade bonds, junk bonds, and commercial paper (short-term).  It also encompasses specialist debt instruments such as collateralized debt obligations, mortgage-backed securities, and credit default swaps (CDS).

Bond Market

The bond market, which is the largest global securities market, is where supranational organizations, governments, banks, and corporations (key issuers), as well as other types of issuers, can borrow money from investors. Borrowers issue different types of debt securities with varying maturities in the primary market, and these securities are subsequently traded in the secondary market. Governments, corporations, insurance companies, investment managers, and individuals all buy bonds.

The US is the largest bond market in the world (accounting for around 40% of the global bond market). The six main types of fixed-income instruments include US treasuries (ranging from one month to 30-year maturities, other US government bonds, corporate bonds, municipal bonds, foreign bonds, and mortgage-backed securities.

This credit market is influenced by the domestic and global economies, the Federal Reserve’s monetary policy, interest rates, inflation, the money supply, the deficit, issuer credit quality, market liquidity, exchange rates, crude oil prices, and other economic indicators. Investors pay close attention to the credit market as it acts as a barometer for the economy.

Credit Rating Agencies

Rating agencies are very important in the global credit markets. Three large global players dominate the segment: Standard & Poor (S&P), Moody’s Investor Service, and Fitch Ratings (together covering 95% of the rating business).

Each agency has a scale for rating securities that ranges from investment-grade at the high end to speculative (junk bonds). Some types of investors, pension fund managers, for example, are limited to investing only in investment-grade bonds.  managers and other asset managers can usually invest in investment-grade credits only.

S&P’s lowest investment grade rating is BBB- rating and BB+ is its highest speculative-grade rating. Fitch Ratings uses the same scale, while Moody’s lowest investment-grade rating is Baa3 and its highest speculative-grade rating is Ba1.

All three agencies have four sub-categories that represent the level of credit risk. For example, Fitch and S&P ratings range from AAA, the highest-rated bonds that bear little credit risk, to BBB-.  Very low-risk issues are rated AA+, AA, and AA-, while low credit risk issues are rated A+, A, and A-. Bonds bearing moderate risk are rated from BBB+ and BBB to BBB-.

All three rating agencies have five speculative-grade ratings, ranging from substantial credit risk (BB+, BB, and BB-) to high (B+, B, and B-), very high (CCC+, CCC, and CCC -), in or near default with the possibility of recovery (CC and C), and in default with little chance of recovery (DDD, DD, and D from Fitch and SD & D from S&P.

Credit ratings reflect relative default risk, which does not decline linearly as credit-worthiness declines. Consequently, credit risk for speculative-grade bonds is significantly higher than that of investment-grade securities.

Credit Spreads

Credit spread can refer to the difference in yield between risk-free treasury bonds and all other bonds. More specifically, the nominal credit spread is the difference in yield to maturity (YTM) between a bond and the treasury security of the same tenor.

Credit spread can also be defined as the difference in yield of two bonds of similar maturity with different credit ratings. For example, if a treasury bond with a maturity of 5 years is trading at a yield of 4% and a corporate bond with the same maturity is trading at 6%, then the credit spread is 2% or 200 basis points. When the spread narrows, an issuer’s creditworthiness is improving, while widening spreads send a negative message.

Formula

Credit Spread = Corporate Bond Yield (%) – Yield on Treasury Bond (%)

For the formula to yield a meaningful result, both bonds must have a similar maturity date.  Since the treasury is risk-free, the higher the spread, the riskier the bond is being compared.

Next, the more time to maturity, the higher the yield tends to be. Consequently, the yield curve (a graphic representation plotting yield against time to maturity) typically slopes upward. During periods when short-term yields are higher than long-term yields, the curve is said to be inverted. This often signals a recession.

In uncertain times, credit spreads widen as investors become more risk-averse and move into government bonds. When the stock market is booming and economic uncertainty is low, credit spreads narrow.  The credit spread for high yield (junk) bonds is wider than the spread for investment-grade bonds.

Specialized Debt Instruments

Credit default swaps (CDS), the most common type of credit derivative, are a contract through which two parties agree to exchange or ‘swap’ their credit risk. The financial agreement is between a buyer and seller who transfer risk between them. Each party to the transaction has a different view on the risk of the instruments underlying the swap, so they exchange the risk of default.

The most common type of CDS involves asset-backed securities. Other types are based on municipal bonds, corporate bonds, mortgage-backed securities, and emerging market bonds as well as other types of credit instruments. CDS contracts are highly customized to the needs of the counterparties.

Mortgage-backed securities (MBS) are created by financial institutions that package residential or commercial mortgages and resell them.

Collateralized debt obligations (CDO) is an example of a complex structured finance product, which is a bundle of loans or packages – auto loans, credit card receivables, corporate loans, or mortgages (i.e. a product) – that are sold by banks to institutional investors in the secondary markets.

Investment Banks and Credit Market Structure

Investment banks both help corporate clients issue debt and maintain credit trading desks to trade bonds in the secondary market. A bank’s debt capital markets group typically includes four divisions

Investment-grade capital markets: Offers corporate and institutional clients by offering advisory services for issuing investment-grade fixed income instruments, as well as sales and execution.

Leveraged finance capital markets:  Works with clients issuing high-yield bonds or involved in leveraged buyouts (LBOs) or recapitalizations.

Structured finance: Works with structured instruments and securitization. Repackages assets including retail and commercial mortgages, car loans, aircraft loans, and more into securities that can be traded. Instruments can include collateralized debt obligations, syndicated loans, and credit default swaps, among others.

Emerging markets: Markets in emerging economies are considered higher risk and credit spreads are significantly higher. Moreover, emerging market bankers have specialized local knowledge and can help issuers gain access to developed markets to sell debt.

Credit Spread Example

Assume that Company A’s bond matures in six years and offers a yield of 4.0%, while the yield on a Treasury bond of similar maturity is 2.5%. Based on the formula introduced above, the credit spread is 1.5% or 150 basis points.

Conclusion

A sound understanding of the credit market is important since it is a primary source of financing for companies, governments, and municipalities and is also significantly larger than the equity market. Credit rating agencies make it easier for inventors to understand the level of risk they are assuming by assigning ratings to fixed income instruments based on the issuer’s credit profile.

Solve the Following Question on Credit Spread

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