THE CREDIT MARKET

INTRODUCTION
In a debt-based economy, credit is the main tool for creating money. It is an act by which a
financial institution makes available to its customers a sum of money in return for the
payment of an interest rate (price of money) for a specific period. Indeed, credit plays a
decisive role in economic growth; the evolution of loans and their use in profitable sectors
will therefore have a positive impact on economic development through increased
investment, production and consumption.

On the other hand, when there is economic growth, some financial institutions tend to
increase the volume of credit because macroeconomic conditions are favourable (which
facilitates repayment). However, when an investor grants a loan, he is only interested in the
return on borrowed capital, his personal objective and his management autonomy; on the
other hand, the lender rather assesses the solvency and the respect of the commitments of
the borrower.

The attention paid to the borrower’s ability to repay therefore encourages lenders to protect
themselves against the risk of default by the client ; if these risks result in very critical costs
for the agency, then the providers are rationing credit. If under normal conditions, why do
banks ration their loans ? Strictly speaking, what is credit rationing ? What are its different
forms, what engages credit rationing ? And what consequences does it have on households
and the economy ? These are the key points that will allow us to better understand the
concept of credit rationing.

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AN OVERVIEW AND DEFFINITION OF

A CREDIT MARKET
A. OVERVIEW
The credit market is the mechanism through which new debt can be issued or in which
existing debt can be traded. As the bond market represents the dominant portion of the
credit market, the terms ‘bond market’, ‘debt market’ and ‘credit market’ are often used
interchangeably. Credit markets and equity markets make up the capital market. The credit
market represents the largest portion: the size of the global bond market is estimated at
USD 102.8 trillion, ** compared with the global equity market capitalization of USD 74.7
trillion. ** In Debt Market, the creditworthiness of the issuer plays a very important role.
Credit Rating agencies like Moody’s, Standard & Poor’s, Fitch, ICRA, etc give credit ratings to
all these debt securities according to their credibility. Investors rely heavily on these ratings,
before investing in debt securities.

1) Debt Market: Meaning

Debt Market is a market place, where buying and selling of debt market financial
instruments take place. These financial instruments are fixed-income securities, giving fixed
returns to the investors. These securities provide regular interest payments at a fixed rate
with principal repayment at the time of maturity. The issuer of these securities can be local
bodies, municipalities, state government, central government, corporate, etc. Major Debt
Market securities are Bonds, Government Bonds, Debentures, Treasury Bills, Certificate of
Deposits, Commercial Papers, etc.

2) Types of credit market

Debt market is divided into two parts, secondary market and primary market. New
instruments are issued in the primary market by various participants. The market for bonds
and securities are bought and sold is called secondary debt market.

a) Issuance in the primary market

Issuance of new debt takes place in the primary market, as a means for governments,
government agencies and companies to raise capital. In buying these debt instruments,
investors lend money to the issuers in exchange for the promise of repayment of the loan
value – or face value, or par value – at a specified future date – the maturity date.

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Depending on how the debt agreement is structured, the buyer may be entitled to a regular
payment, referred to as the coupon.

b) Trade in the secondary market

Once issued in the primary market, debt can be traded in the secondary market. When debt
instruments change hands, the new owners become entitled to coupon payments and the
eventual repayment of the face value upon maturity. Aside from the debt issuers,
participants in credit markets include wealth managers, pension funds, insurers, hedge
funds, traders and retail investors.

B. PARTICIPANTS IN THE CREDIT MARKET

1. Credit Issuers

The issuers sell bonds or other debt instruments in the credit market to fund the
operations of their organizations. This area of the market is mostly made up of
governments, banks, and corporations.The biggest of these issuers is the
government, which uses the bond market to fund a country's operations, such as
social programs and other necessary expenses.
 Municipal bonds—commonly abbreviated as "muni" bonds—are locally issued
by states, cities, special-purpose districts, public utility districts, school
districts, publicly-owned airports and seaports, and other government-owned
entities who seek to raise cash to fund various projects. Municipal bonds are
commonly tax-free at the federal level and can also be tax-exempt at state or
local tax levels too, making them attractive to qualified tax-conscious
investors.

 Companies issue corporate bonds to raise money for a sundry of reasons,

such as financing current operations, expanding product lines, or opening up
new manufacturing facilities. Corporate bonds usually describe longer-term
debt instruments that provide a maturity of at least one year. Corporate
bonds are typically classified as either investment-grade or else high-yield (or
"junk").

This categorization is based on the credit rating assigned to the bond and its issuer.
An investment grade is a rating that signifies a high-quality bond that presents a
relatively low risk of default. Bond-rating firms like Standard & Poor’s and Moody's
use different designations, consisting of the upper- and lower-case letters "A" and
"B," to identify a bond's credit quality rating.Banks are also key issuers in the bond
market and they can range from local banks up to supranational banks such as the
European Investment Bank, which issues debt in the bond market. The final major

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issuer in the bond market is the corporate bond market, which issues debt to finance
corporate operations.

There are four major types of bond classifications: corporate bonds, government
bonds, municipal bonds, and mortgage-backed bonds.

2. Credit Underwriters

The underwriting segment of the credit market is traditionally made up of investment

banks and other financial institutions that help the issuer to sell the bonds in the
market. In general, selling debt is not as easy as just taking it to the market. In most
cases, millions (if not billions) of dollars are being transacted in one offering. As a
result, a lot of work needs to be done—such as creating a prospectus and other legal
documents—in order to sell the issue.

In general, the need for underwriters is greatest for the corporate debt market
because there are more risks associated with this type of debt.

3. Credit Purchasers

The final players in the market are those who buy the debt that is being issued in the
market. They basically include every group mentioned as well as any other type of
investor, including the individual. Bondholders essentially become creditors, or
lenders, to the issuer. If you buy a U.S. Treasury, the federal government owes you
money. If you buy a corporate bond, the company that issued it owes you money.
Bonds are widely considered to be a core part of a well-diversified portfolio.

Governments play one of the largest roles in the credit market because they borrow
and lend money to other governments and banks. Furthermore, governments often
purchase debt from other countries if they have excess reserves of that country's
money as a result of trade between countries. For example, China and Japan are
major holders of U.S. government debt.

C. Types of Debt Market Instruments

In the Debt Market, the trading of many securities takes place. All these securities
individually have a different set of qualities and serve different purposes. All those issuers of
these securities according to their financial requirements and available options selects the
best debt instrument. They are as follows:-
1) Bonds

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Bonds are mainly of two types, i.e. Government Bonds and Corporate Bonds. Government
Bonds holds less risk than Corporate Bonds. Mostly, Corporate Bonds pay a higher interest
rate than Government Bonds. There are other Bonds like Municipal Bonds and Institutions
Bonds. The Bonds have a fixed coupon rate and pay that interest to the bondholder
periodically. And also repay the principal amount at the time of maturity. The interest rates
of bonds are variable in the case of Floating Rate Bonds.

Floating Rate Bonds provide a variable interest rate that fluctuates according to the changes
in the interest rates in the economy. Fixed-Rate Bonds gives fixed interest rates, irrespective
of any market changes. There are Zero-Coupon Bonds, which does not provide any interest
rate periodically or at the time of redemption. Rather these bonds are issued at a discount to
the par value or face value of the bond. And the redemption of such bonds at maturity at the
par value of the bond. The difference between the par value and the discount value is the
return for the investor or we can say that is the interest for the bondholders.

Issuance of Corporate Bonds sometimes takes place with a call option and put option. In the
case of a call option, the company can call back their bonds once a particular time has
passed. In the case of a put option, the investors can sell their bonds, back to the company
after a particular time or date as indicated at the time of issuance.
2) Government Securities

These are debt instruments, mostly issued by the Central Bank of the country, in the place of
the Central or State Government. These securities can be for the long term or short term.
These securities give a fixed coupon rate to the investors. The yield of Government securities
are mostly considered as a benchmark for return and are even considered as a risk-free rate.
Treasury Bills are short-term securities. Long term Government securities include
instruments like Dated Securities or Bonds.
3) Debentures

Debentures are similar in nature to Bonds; the only difference is the security level.
Debentures are riskier in nature. Not only this, Bonds can be issued by the Government and
Companies, but Debentures can only be issued by Companies. Debentures can be of
different types, which are as follows:-

 Registered Debentures and Bearer Debentures

The Registered Debenture is there in the company’s records. The names of the debt holders
and other details are recorded in the company and the repayment of the debenture is made
to that particular name only. These debentures are transferable but need to complete the
transfer process. Recording of Bearer Debentures does not take place. The issuer of the
Debenture is entitled to make the repayment of the bond amount to whoever holds the
debenture certificate.

 Secured Debentures and Unsecured Debentures

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Secured Debentures are backed by collateral security. The Unsecured Debentures have no
backing of any collateral security. Secured are less risky in comparison to the Unsecured
ones.

 Redeemable Debentures and Non-Redeemable Debentures

Redeemable Debentures are repaid at the time of maturity only. Repayment of Non-
Redeemable Debentures takes place at the time of liquidation only.

 Convertible Debentures and Non-Convertible Debentures

Convertible Debentures can be converted into equity shares on a future date. Non-
Convertible Debentures cannot be converted into equity shareholders on any future date.

 First Debentures and Second Debentures

At the time of liquidation, First Debentures have the preference over the Second Debentures
at the time of repayment.

The above-mentioned list does not include all debt market instruments available in the
market. Other instruments are Fixed Deposits, Certificates of Deposits, Commercial Papers,
National Savings Certificates, etc.

D. Who issues Debt Market Instruments?

The debt market is one of the important platforms for raising debt. Debt Market Instruments
helps the issuers to procure funds and satisfy their needs. Many entities issue Debt Market
instruments, which are as follows:-

1. Corporate/ Companies: Companies often rely on debt instruments to finance their

projects, expansion, or growth. Raising money through equity is always not a feasible
option, in such a situation the companies go for Debt Market securities.
2. Banks and Financial Institutions: Banks and Financial Institutions flourish on deposits
and lending business. Debt Market instruments give Banks and Financial Institutions,
an opportunity to raise funds for lending. These institutions and banks accept
deposits from the public at large at a lower interest rate and thereafter lends money
to the borrowers at a higher rate.
3. State and/or Central Government: The State and/or Central Government raises money
through Debt Market instruments to execute its various infrastructural projects and
welfare programs. Sometimes the government does not have enough funds even
after considering all taxes income and other incomes. In such a situation, the
government raises funds through the general public. The infrastructural projects
once start functioning, they repay the government and the same funds are given
back as returns and redemptions to investors.

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4. Local Panchayats or/and Municipal Corporations or/and Local Body: At even small town
or village level, Debt instruments are useful for raising funds. In a similar manner to
Central and State Government, these local Municipalities or Village Panchayats use
these instruments for collecting funds for their infrastructural projects and other
welfare programs.
5. Public Sector Units (PSUs): Public Sector Units (PSUs), have to directly compete with
private entities. These Units also use debt instruments to raise funds for their
projects and expansion.

E. Types of Risks in Debt Markets

Debt Markets, in comparison to other markets, are less risky in nature. Irrespective of that
there are few risks, which are difficult to ignore.
a. Credit Risk or Default Risk

One of the biggest risks in this market is the default risk or credit risk of the issuer. It might
happen, due to unforeseen situations, the issuer loses its credibility and is not able to repay
back the interest and/or principle. Though the debt securities get first preference at the time
of liquidation, it is one of the biggest risks for the investors.
b. Interest Rate Risk

This type of risk prevails almost in all debt market securities. The interest rates of debt
instruments continuously fluctuate in the open markets. There are times when there is a
high-interest rate in the market but the investor has invested for a lower fixed interest rate.
In such a situation, the investors lose on to higher interest rates and get only the fixed
interest rate.
c. Settlement Risk and Liquidity Risk

Settlement of the debt security at times, acts as a risk, as the other party might not fulfill all
requirements. There exist counterparty issues at the time of settlement.

Liquidity Risk acts as an area of concern in the case of debt securities. Sometimes premature
withdrawals are not an easy task to conduct. Premature withdrawals not always provide
ideal returns on their investments.There can always be other risks, associated with the Debt
instruments.

F. Pricing of debt
The pricing of debt instruments is based largely on the credit worthiness of the issuing
entity: if the market has doubts about the ability of a government or a business to meet its
debt service and repayment obligations, it would demand a higher compensation for buying
and holding the debt. 

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General market sentiment, currency risk, political risk, changes in policy interest rates,
regulatory changes that change the business environment, amongst other factors, would
influence this assessment of creditworthiness.

Credit valuation

In credit markets, valuation is reflected in the yield on the debt instrument, which is the ratio
of the annual coupon payment to the market price of the bond. Should the price of a debt
instrument trade lower owing to the view that it has become riskier, the yield on the debt
instrument rises. 

Credit market activity is a barometer of sentiment and thus of likely future economic and
market trends.

a. Calculation of interest on bonds

 Purchasing a bond can be thought of as purchasing debt, or, alternatively stated, loaning
money to a company. The bond itself simply represents this debt. Like any loaned money, a
bond entitles you to receive interest payments at fixed intervals for a specific time frame, at
the end of which you will receive your initial amount back.[1] . Sometimes when you look at
bonds, you will see both a yield and a coupon. For example, the bond's coupon may be 5%,
and the bond's yield may be 10%.
This is because the value of your bond can change over time, and yield is the bond's annual
coupon payment as a percent of its current value. Sometimes bond prices go up and down,
meaning the price of your bond can change from what your face value is.
Example
You issued a bond of 1000frs at an interest rate of 5%, what will be the amount of interest
you receive on each payment.
Sol ; Fv=1000
Coupon rate=5%
Interest on bond= 1000*0.05=50frs
b. Interest on Debentures

A debenture is essentially a long-term loan that a corporate or government raises from the
public for capital requirements. For example, a government raising funds to construct roads
for the public. Debenture holders are the creditors of the issuing company, unlike
a shareholder who is the owner.

Just like bondholders, debenture holders also earn an interest income for investing in the
debt instrument. The coupon rates or interest rates are usually fixed unless when they are of
the floating kind. A fixed rate of interest cushions against market fluctuations, making the
investment less risky.

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Debentures do not allow a claim over the issuer’s assets as they are largely unsecured debt
instruments. The absence of collateral is offset by stable, low risk and better earnings. Also,
a financially stable company with a reliable credit rating attracts investors as it reflects
investment’s safety. Besides, with floating interest rates, earnings become better when rates
improve.

Example 1
The formula for computing total interest paid by the issuer is as follows –
Interest Expense = Interest Rate/ 100 * Debt Amount
ABC Ltd. issued 240000frs debentures at 5% coupon rate. Determine the interest
paid.
 Interest Expense = 5/100 * 240000
 Interest Expense = 12000frs
Example 2
Whether the repayment methodology involves lump-sum or installment repayment,
investors always try to find out the present value or the fair value of the investment.
It helps in ascertaining its profitability. Therefore, let us calculate the debenture
value when the repayment occurs in installments.
With each installment, the interest declines since the interests are calculated on an
outstanding principal amount. When one deducts a repayment installment from the
total debt, they are left with an outstanding principal amount. Therefore, we will
need to calculate the present value of future interest payments and installments
using a required rate of return (yield to maturity)
Debenture value= (I1+P1)/(1+r)^1 +(I2+P2)/(1+r)^2+……….(I3+P3)/(1+r)^n
= ∑ t=1to n (It+Pt )/ (1+r)t
Where,
 It= Interest payment for a particular period
 Pt=Principal payment for the same period
 r = Yield to maturity/ Required rate of return
An entity is issuing a debenture of 5 years, 1,000frs to be remitted in equal
installments at an 8% percent interest rate. The minimum required rate of return is
10%. Calculate the investment’s present value.
A table depicting the discounted cash flows in each period is shown below:

YEAR CAPITAL PAYMENTS INTEREST CASH DISCOUNTING PV OF

FLOW FACTOR CASH
FLOW
1 1000 200 80 280 0.91
2 800 200 64 264 0.83 218.18
3 600 200 48 248 0.75 186.33
4 400 200 32 232 0.68 158.46

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5 200 200 16 216 0.62 134.12

TOTAL PRESENT VALUE OF DEBENTURE 951.63

G. Advantages of Debt Market

 The debt market capitalizes and mobilizes the funds in the economy.

 This market gives a platform to the government, companies, and other bodies to
raise funds.

 Sometimes raising equity becomes very costly for the corporate. In such a situation
raising money through the debt market is the best possible option.

 This market gives fixed returns to investors with lesser risk. Government Debt Market
securities are less risky than Corporate Debt securities.

 In absence of any other sources of finances, the Central/State Government takes the
help of this market. It saves the Government bodies, from suffering from any cash
crunch.

 Debt Market securities backed by assets get the preference as compared to other
unsecured and business debts, at the time of liquidation.

 The money raised through this market helps the companies to boost its expansion
and growth plans.

 The debt market helps the Government authority to boost infrastructural projects.

These advantages are non-exhaustive in nature.

H. Disadvantages of Debt Market

 One of the biggest disadvantages of this market is that it provides fixed returns to the
investors and completely ignores the inflation rate. The inflation can make the actual
return falls down to a record low.

 The second disadvantage is, in the case of premature withdrawal or sell-off in the
market, the investor gets the current market bond’s price and not the principal
amount invested. It is possible that the company might lose its credibility and the
bond prices might have fallen down.

 The investors will get a fixed interest rate return only, irrespective of an increase in
the interest rate in the market.

 For issuing authority, it becomes very difficult to get a good credit rating. This
becomes the biggest task to meet all requirements of credit rating agencies.

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These disadvantages are non-exhaustive in nature.

Conclusion
The debt market is one of the important market place, which keeps the economy running. It
channelizes the funds in a productive way and benefits the issuer and the investor. Starting
from Government to Corporate uses this market as a source of finance. For investors, it acts
as a fixed- regular source of income.

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References
Footnote: ** SIFMA estimates for 2018, measured as total outstanding debt (September
2019)

https://corporatefinanceinstitute.com 

Beirne J, L. Dalitz , J. Ejsing, M. Grothe, M. Simone, F. Monar, B. Sahel, M. Susec, J Tapking

and T.

Vong (2011), ―The Impact of the Eurosystem‘s Covered Bond Purchase Programme on the

Primary and Secondary Markets‖, Occasional Paper Series, ECB, No 122, January 2011.

Blommestein H., A. Keskinler, C. Lucas (2011), ―The Outlook for the Securitisation Market‖,
OECD

Journal: Financial Markets Trends, Vol.2011/1.

IMF (2009), ―Restarting Securitization Markets: Policy Proposals and Pitfalls,‖ Global
Financial

Stability Report, Chapter 2, October.

www.googlescholar.com

FINANCIAL MARKET EXPOSER : GROUP 2