Credit Market: Definition, Types, Example

What Is the Credit Market?

The credit market is the market through which companies and governments issue debt to investors, such as investment-grade bonds, junk bonds, and short-term commercial paper. Sometimes called the debt market, the credit market also includes debt offerings, such as notes and securitized obligations, including collateralized debt obligations (CDOs), mortgage-backed securities, and credit default swaps (CDS).

Key Takeaways

  • The credit market is where investors and institutions can buy debt securities such as bonds.
  • Issuing debt securities is how governments and corporations raise capital, taking investors' money while paying interest until they pay back the debt principal at maturity.
  • The credit market is larger than the equity market, so traders look for strength or weakness in the credit market to signal strength or weakness in the economy.

Understanding the Credit Market

The credit market dwarfs the equity market in terms of dollar value. As such, the state of the credit market acts as an indicator of the relative health of the markets and the economy as a whole. Some analysts refer to the credit market as the canary in the mine because the credit market typically shows signs of distress before the equity market.

The government is the largest debt issuer, issuing Treasury bills, notes, and bonds, with maturity durations of anywhere from one month to 30 years. Corporations also issue corporate bonds, the second-largest portion of the credit market.

Through corporate bonds, investors lend corporations money they can use to expand their business. In return, the company pays the holder an interest fee and repays the principal at the end of the term. Municipalities and government agencies may issue bonds, which are used to fund projects and programs. For example, a municipality bond may be issued to support a city housing project.

Types of Credit Markets

In an economy, there are generally two types of credit markets; formal and informal. An informal credit market is one that a government does not control. A formal credit market is controlled by a government, which is most common in developed countries.

In developed countries with regulated credit markets, corporations, national governments, and municipalities can issue bonds when they need funding. Investors who buy the bonds essentially loan the issuer money. In turn, the issuer pays the investors interest on the bonds, and when the bonds mature, the investors sell them back to the issuers at face value. However, investors may also sell their bonds to other investors for more or less than their face values prior to maturity.

Other parts of the credit market are slightly more complicated, and they consist of consumer debt, such as mortgages, credit cards, and car loans bundled together and sold as an investment. As payments are received on the bundled debt, the buyer earns interest on the security, but if too many borrowers (in the bundled pool) default on their loans, the buyer loses.

Credit Market vs. Equity Market

While the credit market gives investors a chance to invest in corporate or consumer debt, the equity market offers investors a chance to invest in a company's equity.

For example, if an investor buys a bond from a company, they are lending the company money and investing in the credit market. If they buy a stock, they are purchasing a share of the company itself.

Depending on the type of stock and what the company grants to investors, this means that they can take part in its profits, assume a share of its losses, or experience increases or decreases in the company's market value.

Credit Market Example

In 2017, Apple Inc (AAPL) issued $2 billion in bonds that mature in 2027. The bonds pay a coupon of 2.9%, with payments twice per year. The bond has a $1,000 face value, payable at maturity.

An investor looking to receive steady income could buy the bonds—assuming they believe Apple will be able to afford the interest payments through to 2027 and pay the face value at maturity. At the time of the issue, Apple had a high credit rating. The investor can buy and sell the bonds anytime, as they are not required to hold them until maturity.

Between the Sep. 12, 2017 issue date and Aug. 10, 2023, the bonds had a bond quote ranging from $92.69 in October 2018 to $113.65 in July 2020. They then declined in price to hover between $91.53 October 2022 and $96.39 in April 2023.

This means the bondholder could have received the coupon but also seen their bond value increase if they bought at the lower end of the range. People buying near the top of the range would have seen their bonds fall in value but still received the coupon.

Bond prices rise and fall due to company-related risk; however, they primarily fluctuate because of changes in interest rates in the economy. If interest rates rise, the lower fixed coupon becomes less attractive, and the bond price falls. If interest rates decline, the higher fixed coupon becomes more attractive, and the bond price rises.

Special Considerations

Prevailing interest rates and investor demand are both indicators of the health of the credit market. Analysts also look at the spread between the interest rates on Treasury and corporate bonds, including investment-grade and junk bonds.

Treasury bonds have the lowest default risk and, thus, the lowest interest rates, while corporate bonds have more default risk and higher interest rates. As the spread between the interest rates on those types of investments increases, it can foreshadow a recession as investors begin to view corporate bonds as increasingly risky.

What Is the Role of the Credit Market?

The credit market plays a vital role in a country's economy. It is a market where governments, corporations, or other entities can issue bonds in exchange for capital to fund projects or programs.

What Is the Difference Between the Credit Market and the Debt Market?

Debt market is another term used to refer to the credit market, so they are the same.

What Are the Two Kinds of Credit Markets?

There are generally two kinds of credit markets in an economy. One is a formal credit market regulated by the government, and the other is informal, which means it is not regulated.

The Bottom Line

A credit market is a market where investors, entities, or individuals can make loans to others in return for interest or other compensation. Developed economies such as the U.S. generally have formal credit markets, which are regulated.

Governments, municipalities, and corporations can use the credit market to issue bonds in exchange for capital from investors to fund projects or programs. The investors are usually incentivized with interest payments or a promise of an increased value when the bond matures.

Article Sources
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