Last Updated on 7 April, 2022 by Samuelsson
Certain terms mean different things in the business and financial trading worlds, and credit trading is one of them. Now, you may be wondering what the term is all about.
In the business world, trade credit is a business agreement where the buyer is allowed to get the goods and pay on a later date. However, in the financial trading world, which is what we are focused on, credit trading implies trading the credit market, which refers to the debt market via which governments and corporations issue debt securities, such as investment-grade bonds, junk bonds, and short-term commercial paper, to investors.
In this post, we will discuss the following:
- What is credit trading?
- Understanding credit trading
- Types of credit trading
- An example of credit trading
- Why trade the credit market
- Credit trading vs. equity trading
What is credit trading?
The term means different things in business and financial trading. We will take a brief look at both definitions and then focus on what it means in financial trading, which is our main area of concern.
Trade credit: Business definition
Here, trade credit is a business agreement where the buyer is allowed to get the goods and pay on a later date. That is, it’s an understanding between two parties engaged in business with each other that allows the exchange of goods and services without the immediate exchange of money.
In the business world, when a business allows the buyer to pay for the goods or services at a later date, the business is said to extend credit to the buyer. Usually, firms that operate with trade credits give buyers 30, 60, or 90 days to pay, and such transactions are recorded in an invoice. In the accounting book of the selling firm, the trade credit would appear as accounts receivable, while in the buyer’s accounting books, it would appear as accounts payable.
To the buyer, trade credit can be thought of as a type of 0% financing, requiring no interest to be paid in relation to the repayment period. In some cases, the buyer may even get a discount for early payment. For instance, a customer granted credit with terms of 4/10, net 30, means that the customer has 30 days from the invoice date to pay the seller and can also get a cash discount of 4% if payment is made within 10 days of invoicing.
Business-to-business trade credit can help the receiving firm to obtain, manufacture, and sell goods before ever having to pay for them, allowing it to receive a revenue stream that can retroactively cover costs of goods sold. One of the well-known businesses that use trade credits is Walmart; it pays retroactively for goods sold in their stores.
Credit trading: Definition in financial trading
In financial trading, credit trading means trading the credit market, also known as the debt market via which governments and corporations issue debt securities, such as investment-grade bonds, junk bonds, and short-term commercial paper, to investors. To raise capital to finance their projects, governments and corporations issue these debt securities, collecting money from investors and paying interest until they pay back the debt principal at maturity.
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). The credit market is larger than the equity market, and as a result, the state of the credit market can indicate the collective health of the economy.
Traders look for strengths or weaknesses in the credit market to have an idea about the state of the economy. Some financial analysts describe the credit market as the canary in the mine because the credit market shows signs of distress before the equity market does.
Related reading: Can You Get a Mortgage As a Trader?
Understanding credit trading in the financial markets
Unlike corporations, the government can only raise money via the credit market. So, when a government entity needs to raise money, it issues bonds to investors in exchange for their cash. For loaning money to the government, the investors are paid regular interests on the loan until maturity when the government pays back the principal. All through the period of the loan until maturity, the investor can sell the bond to other investors that are willing to buy it. This trading of loans between investors is known as credit trading.
Although the government is the largest issuer of debt, issuing Treasury bills, notes, and bonds, which have durations to maturity of anywhere from one month to 30 years, corporations also issue corporate bonds, and those bonds make up the second-largest portion of the credit market.
Apart from issuing bonds, corporations can also raise money by issuing equities but that can dilute their share value. When raising money through corporate bonds, investors lend corporations money to use for their business projects, and the company pays the holder a regular interest fee until maturity and repays the principal at the end of the term. These debt investors have no share in the company’s equity.
Apart from bonds, other aspects of the credit market include collateralized debt obligations (CDOs), mortgage-backed securities, and credit default swaps (CDS). There are also consumer debts such as credit cards, mortgages, and car loans. These aspects are complicated to deal with as they receive payments on bundled debt and sell as an investment known as bundled debts. The buyer earns interest on the security. If many borrowers default on their loans, the buyer loses money.
When trading the credit market, there are two factors you must always consider — prevailing interest rates and investor demand. Many analysts tend to watch the spread between the interest rates on treasury bonds and corporate bonds. While Treasury bonds normally have the lowest default risk and the lowest interest rates, corporate bonds have higher interest rates and more risk by default. As the spread between the interest rates on those types of investments increases, it shows that investors are viewing corporate bonds as increasingly risky.
Types of credit market instruments
Basically, there are four types of credit market instruments, and they are as follows:
A simple loan refers to a credit market instrument giving the borrower some funds that must be repaid to the lender at the date of maturity along with an extra payment (interest).
Like all loans, simple loans are usually repaid in equivalent, monthly installments after you collect the loan. Take an auto loan, for example, the bulk of vehicle loans interest on the principal collateral balance is measured every day, and charges are made first to any interest owed and then to the principal amount.
The interest is charged monthly as interest is often derived from the excess of the fund, the maximum at the outset of the loan. However, as the duration of the loan progresses, you pay less and more for the interest.
Fixed Payment Loan
A fixed-rate repayment is an interest-rate revolving loan whose interest cannot be adjusted during the loan’s duration. While the amount of expenditure will appear to be the same, the percentage that goes to interest expenditure and payment differs. Banks do offer adjustable-rate credit products, and these may traditionally have an initial interest rate considerably lower than fixed-rate payment financing.
Homebuyers typically get a much cheaper promotional rate to a flexible mortgage rate, which will directly after the transaction offer a split in payments. Fixed-rate mortgage loans can have floating rates, but it’s the homebuyers that determine which form of interest is the right option.
Often called a bond bearer or bonds coupon, the coupon bond is a loan obligation with coupons attached which signify semiannual interest payments and is. The issuer of the coupon bond does not have a record of the buyer, nor does the buyer’s name appear on some form of a certificate. In the time from the issue of the bond to maturity of the bond, bondholders shall collect those coupons.
The coupon rate at the date of issuance determines the return on the bond and can change the value of the coupon. Bonds with higher coupon rates offer better returns and attract more investors.
Discount bonds are bonds sold for less than their face value. The buyer of such bonds earns interest from the owner of the bond, which typically comes semiannually but can also be structured monthly, quarterly, or annually, depending on the contract. Both retail and private investors may buy and sell discount bonds. A typical example of a discount bond is the U.S. savings bond.
Credit derivative products
These are financial contracts that allow parties to minimize their exposure to credit risk. Common examples include collateralized debt obligations and credit default swaps.
Collateralized debt obligations
A collateralized debt obligation (CDO) is a credit derivative product that is backed by a pool of loans and other assets. As its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.
The earliest CDOs were constructed by the former investment bank, Drexel Burnham Lambert in 1987. Investment banks create CDOs by gathering cash flow-generating debt assets, such as mortgages, bonds, and other types of debt, and repackaging them into discrete classes based on the level of credit risk assumed by the investor.
These classes of securities then become the final investment products, whose names can reflect their specific underlying assets. Mortgage-backed securities (MBS), for example, consist of mortgage loans, while asset-backed securities (ABS) comprise corporate debt, auto loans, or credit card debt.
Credit default swaps
Credit default swaps (CDS) are debt derivative products that allow an investor to swap or offset his or her credit risk with that of another investor. For instance, if a debt-instrument investor is worried that a borrower is going to default on a loan, the investor could use a CDS to offset or swap that risk. Most CDS contracts are maintained via an ongoing premium payment, just like the regular premiums on an insurance policy.
To swap the risk of default, the investor buys a CDS from another investor who agrees to reimburse him/her in the case the borrower defaults. The CDS is designed to transfer the credit exposure of the underlying credit instrument to the seller of the CDS.
For the CDS seller to assume the risk, the buyer makes payments to him/her until the maturity date of a contract. In return, the seller agrees that — if the debt issuer (borrower) defaults or experiences another credit event — the seller will pay the buyer the security’s value plus all interest payments that would have been paid between that time and the security’s maturity date.
CDS is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities, or corporate bonds.
An example of credit trading
Let’s take a look at Apple’s $1 billion bond issue in 2017. The bond has a 10-year maturity period — matures in 2027 — and pays a coupon of 3%, with twice-yearly payments. The face value of the bond, payable at maturity, is $1,000.
So, an investor who wants to receive steady income could buy the bonds if, in his or her assessment, Apple can afford the interest payments through to 2027 and also pay the face value at maturity. Moreover, the investor can buy and sell the bonds at any time, as it is not required to hold the bond until maturity.
At the time of the issue, Apple had a high credit rating, so investors were eager to buy. Between April 2018 and April 2019, the bonds had a bond quote that ranged from 92.69 to 99.90. Thus, the bondholder could have received the coupon but also seen their bond value increase if they bought at the lower end of the range. However, those buying near the top of the range would have seen their bonds fall in value — though, they would have still received the coupon.
While bond prices can rise and fall due to company-related risk, they mostly fluctuate because of changes in interest rates in the economy. When interest rates rise, the lower fixed coupon becomes less attractive and the bond price falls. On the other hand, when interest rates decline, the higher fixed coupon becomes more attractive and the bond price rises.
Credit trading vs. equity trading
As an investor, you can trade both the credit market and the equity market. In the credit market, you trade corporate or government debt securities and make money from interest and value appreciation. On the other hand, trading the equity market allows you to own a share of a company, including voting rights, as well as gives you the chance to profit from dividend payments and capital appreciation.
When you are trading credit instruments, you are lending money to the company or government agency that issued the instrument, but investing in equities offers you part ownership in the company you are buying.