Credit markets are often defined as the backbone of investment and economic activity. It is a market system wherein companies, institutions, co-operative units issue debt in a graded manner to investors and buyers alike. These debts can be in various and under various conditions depending upon the forces of demand and supply.
Hence the different types of credit markets are based on the different kinds of instruments available in the credit market. Since the primary purpose is to raise investment potential via debt, the credit market can be classified on the products and services it offers to the buyers and seller. Such of the popular debt instruments sold in credit markets that define the credit market category are:
As the name suggests, these bonds are graded depending upon the return expected and risk associated. The grades may vary from institution to institution or from time to time. Some of these bonds are classified based on certain conditions imposed upon the buyer and seller.
These bonds are used by companies to raise capital to fuel their business plan. Hence this is generally a long-term option to raise funds. Sometimes the investment-grade relationships sold on credit markers are strategic. Therefore, the company buys the investment-grade bonds and, apart from financial terms, offers strategic partnership deals. This leads to the forging of a new partnership between the two entities and is generally used in cases of mergers and acquisitions.
These bonds have a high degree of risk associated. These are generally those binds that have few takers. Junk bonds attract a particular category of bidders who accumulate junk bonds and then build a portfolio. Since junk bonds have high risk, they also deliver high returns. So by gathering junk bonds, risks are minimized since even if apportion of the bind turns profitable, this leads to high yields.
These commercial papers are used to raise debt for a short period. Generally used as a stop-gap measure, short term commercial papers are used to raise money for a specific project, debt repayment, or tide over any short-term balance of payment crisis. Since the commercial paper is only for the short term, the rates are generally high, and companies resort to this as a last resort.
A credit default swap is generally a safety mechanism in place when the borrower defaults or is unable to meet the financial obligations outlined in the contract. Once the borrower defaults in the debt payment, the lender can swap the borrowed amount by any other method.
This is done by explicitly outlining in the contract the part regarding the buyer’s losses. Hence the option can be exercised when the default happens and enforced accordingly. Since these bonds are relatively fewer riskers, they generally come up with a lower return rate. Companies borrow money using this option to fulfill their long-term needs and business plans.
Apart from the instruments mentioned above, several other debt instruments are prevalent in the credit market. Some of the less popular and hence less used devices are mortgage-based-securities where the mortgage securities are sold by insurance companies or securitized obligations where there are certain obligations on both the parties for the contract to stand etc. These instruments are not accessible and are sued in certain conditions depending upon the nature of the industry and the requirement of the borrower.
Apart from the above-discussed classification, there exits another classification to distinguish between the types of credit market. These are done based on the nature of the participants in the credit market and are discussed as follows:
These markets are fully regulated and backed by the government at various levels. The government has a direct say in the functioning of instruments in these markets and can manipulate the forces of demand and supply. The bonds are graded, and consequently, their returns are decided to a great extent by the government. Since the government grades the binds, it may lead to the subversion of market forces.
Since it is directly involved in the functioning and intricacies of the credit market, there exists a tacit understanding that the instruments are backed by government support. This leads to an artificial buffer in the market. Hence the performance of such a market is a direct reflection of the performance of the government. In some instances, in such markets, the government might be the most critical buyer of bonds and debt. Hence since the government has the highest purchasing power, such demands are again influenced by the demand-side dynamics laid down by the government. So now the government can increase the prices, return artificially, which is detrimental in the long run.
These types of credit markets are the exact opposite of the government-backed credit market. Here the returns and investment grades are governed by the market forces of demand and supply. The barriers to entry and exit are low, and as such, any participant can offer products and services based on their policy. This type of credit market allows buyers and sellers to come up with customized products and services to suit their demand. Since market forces of demand and supply govern it, there is considerable fluctuation in the services and return offered. These credit markets generally have global acceptance and are used by companies, governments, and institutions to raise debt from overseas markets.
As they are free from government intervention, they have their own set of rules, regulations, and governing mechanisms. Since they are fully autonomous, the buyers and sellers depend upon their reputation to drive a better deal. The regulatory authority has no legal obligation in these types of credit markets.
Credit markets are mostly debt market where institutions can raise loans on a short term or long-term basis in a graded manner. Given their importance and dynamics, they have assumed great significance in the past decade.
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