The World of Credit
The world of credit primarily refers to the credit market where individuals, investors, and institutions, including governments, can buy and issue debt. Credit, then, is simply a different way of referring to debt and is really just the other side of the trade whenever someone issues debt. There are a lot of ways credit and debt can manifest themselves, such as bonds, commercial paper, mortgages, or credit cards, but they all have to do with a creditor (lender) giving a debtor (borrower) money. The terms for these deals will vary quite a bit, but debtors generally pay some sort of interest rate to whomever is lending to them and that interest rate largely depends on the debtor’s credit rating or perceived risk of default. I’ll discuss this in more detail later, but let’s get into explaining some of the most poplar forms of credit, starting with bonds.
Bonds
Considering the global bond market is nearly $120 trillion and the US bond market is over $45 trillion, bonds probably deserve more attention than they get and it’s an area of the market you should familiarize yourself with if you want to be an investor worth his or her salt. For those wholly unfamiliar, a bond is just a loan made by an investor to a borrower. People commonly refer to bonds as I.O.Us because they are a liability a government or business owes to an investor. Bond issuing entities use bonds as a way to raise money in the short term and pay investors interest for fronting them that money. Interest payments continue until the bond’s maturity at which point the issuer repays the full principal value originally loaned to them. So you eventually get your full investment back, or at least that’s the agreement, and you get scheduled interest payments known as coupons until the maturity date.
A few more important features of bonds to note are they start with a face value when they are issued known as the par value, they pay fixed coupon (interest) rates (unless it’s a zero coupon bond), and they all fluctuate according to market conditions. If there is large selling pressure for a specific bond, the yield will rise to compensate for the falling value, and if people bid up a specific bond, the yield will fall to account for the increased value. Because bonds promise to pay a fixed coupon rate (interest payment), yields and bond values will move in opposite directions to maintain that coupon level. If a bond worth $1,000 has a yield of 1% with a coupon payment of $10 per year and yields move to 2%, the value of that bond will fall to maintain that $10 coupon, which would translate to a face value of $500 because 2% of $500 is $10. You don’t have to focus too much on the math, just know yields and bond values move in opposite directions.
Now, the yield for a bond will vary depending on the risk level of the bond issuer and can range anywhere from negative territory like -1%, which I’ll explain toward the end of this article, all the way to double digit yields. The US or other large, currency-issuing governments, for example, being the least risky borrowers who can always print the money they need, will generally have the lowest yielding bonds. Companies, however, who have a much higher chance of defaulting, will have higher yields to entice investors to take that extra risk and lend to them. Some bonds can be secured by collateral that, in the event of default, is awarded to the lender as compensation, but most bonds, including government bonds, are unsecured meaning they are only backed by the good faith of the borrower. Secured bonds can deliver slightly lower yields for the added safety, but all bond yields are largely based on credit ratings.
Credit ratings signal the perceived risk of default as decided by credit rating agencies like Standard & Poor’s or Moody’s. These agencies decide the solvency and financial risk of various bond issuing entities and give them a letter rating. AAA is the highest, least risky rating, and BB+ and below are the riskier junk-grade or subprime level of bonds. These ratings apply to all types of bond issuers, including governments, and carry meaningful implications for institutions who can only hold investment-grade bonds or a certain amount of junk bonds. That said, these are some of the nuances I won’t be getting into as I will just be focused on explaining the main types of bonds, namely, treasuries, TIPS, and corporate bonds.
Treasuries
Treasuries are unsecured government-issued debt or fixed income securities with varying dates of maturity. Outside of taxes and money printing, treasuries are how governments raise capital for their spending. There are a few different treasury classifications relating to maturity dates that can be confusing, so let’s quickly explain some of the terms you might hear. Treasury bills (T-bills) are short-term debt obligations with a maturity of one year or less, treasury notes (T-notes) are debt obligations with maturities from two to ten years, and treasury bonds (T- bonds) are longterm debt obligations with 20 or 30 year maturities. Yields for shorter duration bonds will usually be lower than the longer duration yields as investors expect to be compensated for their extra waiting and and time-related risk, but they all operate under the same rules previously mentioned.
TIPS
TIPS is an acronym for treasury inflation-protected securities. TIPS are very similar to regular treasuries with a couple key differences. One difference is they are only issued with maturities of five, ten, and 30 years, but the main difference has to do with, you guessed it, inflation. Normal bonds or treasuries base their interest payments off the face value of the bond. The value of the bond may rise and fall as yields rise and fall, but the total principal expected to be paid out at the maturity date never changes. With TIPS, however, the principal will increase or decrease with inflation as measured by the consumer price index or CPI. Your principal value will grow or fall to account for inflation all the way up to maturity and every six months when the interest is paid, those payments will reflect that new, inflation-adjusted value. For example, if the original principal value was $1,000 and CPI was 5%, your principal would increase to $1,050 even if yields didn’t move and your interest payments would now be based on the new $1,050 principal. So if the yield was 1%, the $10 interest payment would be $10.50. And in the unlikely event that deflation persists and your principal falls below the initial value, you still have the option to receive your original principal in full at maturity rather than a deflation-adjusted value.
Now, if at this point you’re thinking why wouldn’t everyone choose TIPS over regular treasuries, there has to be a catch, then you would be right. The first catch is simply you are relying on CPI being accurate, which most people acknowledge is not a reliable metric for real inflation in the economy. The second catch is TIPS have lower yields than their regular treasury counterpart meaning the 10Y TIPS yield isn’t as high as the regular 10Y treasury’s. This difference can be significant and, at the moment, TIPS yields are actually negative. The spread between the TIPS yield and the regular treasury yield is what’s known as the inflation breakeven and represents the market’s expectation for average inflation. In other words, TIPS are only worth buying over regular treasuries if you believe inflation will beat that expectation. All this makes the choice between TIPS and regular treasuries a little difficult and so it’s often advised to have a combination of the two, but knowing all this should make strategizing a little easier.
Corporate Bonds
The main difference between corporate bonds and treasuries, aside from the issuer, is their risk level. Government bonds are considered relatively risk-free so they don’t offer the same high yields many corporate bonds do. That higher yield obviously comes with more risk of default, but that is just the trade off you have to make for the higher return. You can be very selective about your risk level by choosing some of the safest corporate bonds like those issued by Microsoft or Apple, but those may not yield much more than government bonds. To earn serious yields, you have to go further out on the risk curve to companies with lower credit ratings. The lower the rating, the higher the yield because the higher the risk. Aside from the extra risk and higher yields, there aren’t really any significant differences between corporates bonds and treasuries.
Commercial Paper
Though technically not a bond, commercial paper is very similar to short-term corporate bonds and can probably be thought of as just that for most intents and purposes. Like many bonds, commercial paper is unsecured meaning it is not backed by collateral or protected by some guarantor, rather, it’s backed by the reputation of the issuer. Given the risks associated with buying unsecured debt for relatively small gains off of pure reputation, commercial paper is usually only issued by institutions with high-quality debt ratings. These institutions will issue debt to meet short-term liabilities like inventory or payroll and then pay that debt back in a month or so. The maturity of commercial paper debt is a little open ended, but it’s never more than nine months and usually matures in about 30 days. Whenever corporations need financing, they will issue commercial paper at a discount to its face value and then pay the lenders the face value at maturity, giving them a small incentive to lend in the first place.
Collateralized Debt Obligations
Though collateralized debt obligations or CDOs are technically a derivative because their value is derived from a pool of loans, it makes more sense to view them through the lens of the credit markets. Banks use CDOs to package a bunch of individual loans like car loans, credit card debt, mortgages, and even corporate debt into one product they can sell to investors. By selling these loans, banks relinquish all the risk of default and simultaneously collect a premium from the investor they can then use to issue more loans. And the investor, by buying a CDO, now earns the cash flow generated from all those loans, but also assumes the risk of default for that basket of loans. Like most credit investments, the risk is outlined by the credit rating of these CDOs, but the great financial crisis of 2008 showed these ratings are not always an accurate reflection of the risks. They can still be good investments, but the bank’s willingness to surrender the yield from these loans should be a warning sign that CDOs can have more risk than reward, especially when they include large amounts of consumer debt that has a much higher probability of default.
Commercial Debt
Commercial debt or business debt is somewhere in between corporate and consumer debt because it’s how individuals start businesses that can grow into corporations. Everybody knows starting a business can be expensive and most people have to get a line of credit from a bank to fund the initial overhead and operational costs. Frequently, business loans will require the borrower to post some kind of collateral like a home to support any loan the bank issues, but if you have excellent credit or a business already demonstrating clear cash flow, it’s possible to get un-collateralized loans. Collateralized or not, though, a very important detail about getting a business line of credit is it allows you to borrow up to a certain amount but only pay interest on the amount you are actually using. For example, if your business line of credit is $100,000, but you are only using $50,000, that is the amount on which interest is charged. A business line of credit is among the most flexible types of loans and can help support general working capital needs as they present themselves. That said, you’ll still need to explain exactly what you need the loan for if you want a bank to sing off on it so don’t expect to get a loan if you’re too open-ended about its use. Also make sure your business generates enough cash flow to pay off your debt payments and interest before committing to a loan. It can take a while to get cash positive, but as long as you can stay afloat through the lifetime of your debt payments despite paying yourself and supporting other business expenses, it should be worth your while to get a businesses loan.
Consumer Debt
We’ve covered government and corporate debt, which are well known in the investment world, and now a little bit of commercial debt, but consumer debt is the type of debt people are probably most familiar with as it is something individuals interact with on a daily basis. Whether it’s our credit cards, college debt, car loans, or a mortgage, consumers take out and pay off debt all the time. As of late 2021, consumer debt was just shy of $15 trillion or over $92,000 per person. This may pale in comparison to the bond market, but it’s by no means a small number and given our intimate relationship with consumer debt, it could be the form of debt you have the most to gain from by learning how it works. Let’s start off with good ol’ credit cards.
Credit Cards
Everybody knows what credit cards are and the basics of how they work, but I think a lot of people still don’t pay too much attention to the fine print about interest rates, cash back, or some of the other important details. I understand paying off a credit card’s balance isn’t always an option, so, if you are someone who makes minimum payments, it would behoove you to do some research and find a card with a reasonable APR. As you accumulate credit card debt, the difference between a 15% and 18% interest rate is huge. The higher your rate is, the more likely you are to dig yourself into a hole so deep your income can never outpace the interest being added. There are a lot of other factors to consider when getting a credit card, but if you fall in the camp of those who make minimum payments, finding the card with the lowest APR should be your priority.
On a happier note, other commonly overlooked aspects of credit cards are their rewards or cash back policies. Many people probably don’t even know what their card’s reward policies are and that’s something that should change. There are cards that offer you straight cash back on all purchases, higher percentage cash back on groceries or gas, some cards that pay for your Netflix subscription, and even cards that pay you in Bitcoin. Finding the right card for your lifestyle can be a serious money saver or just add a little excitement to an otherwise boring service, so keep rewards in mind whenever you’re considering a card and find the best ones for you and your spending habits.
Another important consideration for credit cards is how they affect your credit score. Credit scores are extremely important as they help you qualify for bigger loans or just more favorable loan terms. A great way to help boost your credit score is to pay on time each month, go figure. Timely credit card payments account for 35% of your credit score so it’s crucial to getting and keeping that number high. Another way to help your credit score is to never max out your credit card before paying it off. The ideal percentage to shoot for before paying off your card is 30% of your available credit so try to get in the habit of paying it off whenever you reach that point. The last recommendation I’ll offer is to not close any credit cards. Closing cards reduces the amount of credit available to you and can lower your credit score so, even if you don’t use a credit card, don’t close it. It’s better to just leave it open and forget about it.
Mortgages
Mortgages are arguably the most important form of debt for consumers as they are the largest and allow people to buy their most important asset (though it’s technically a liability until you pay it off). Most houses are far too expensive for consumers to pay out of pocket, so mortgages are an essential form of debt and getting one is certainly the expectation for the majority of home buyers. Once you’ve saved about 15-20% of the value of the home you want for a down payment, you should be in a good spot to buy. But the down payment isn’t the only concern, so make sure you can afford the mortgage payments before you go looking to make any down payments. Mortgages front you the money you need to buy, but you’ll still have to pay that loan off through monthly installments over an extended period of time (usually 15 or 30 years). If, for example, a home you were looking to buy was $350,000 and you only had $50,000 to put down, you can go to the bank to get a $300,000 loan with a fixed interest rate you pay over a 30 year period. You can pay faster if you would like and a lot of people do as it saves you a lot in interest, but your monthly payments should perfectly pay off the loan and interest by the last month of the 30 years. It’s important to note, however, you don’t have to live in a house for the entirety of your loan term. If you want to move and sell your home, you use the money from the sale to pay off the remainder of your loan and you keep whatever equity you have in the house. This is a lot different than renting because when you move as a renter, you don’t get to keep any of the money you’ve spent to live there. This is one of the biggest advantages of owning assets vs renting them. Owners get back most of what they put into their home when they sell, whether that’s the mortgage payments or renovations—renters do not.
The last point on mortgages I want to discuss is about refinancing. Refinancing your home is just redoing your mortgage if/when a more favorable interest rate is available. Lowering your interest rate by just a percent can save you tens of thousands of dollars so it’s worth considering if the opportunity presents itself. One drawback of refinancing a mortgage, however, is that it often resets the clock on your repayment schedule, which can not only cost you more money in interest than necessary, but it can also drag out the repayment process. For example, say you've been making payments on a 30-year loan for five years and you decide to refinance to another 30-year loan at a more favorable rate. While you'll lower your monthly payments, you'll also be five years older when you finally get that mortgage paid off (assuming you stick to the normal payments). On the other hand, if you refinance to a shorter term (say, from a 30-year loan to a 15-year loan) to take advantage of a more favorable rate, you'll save money on interest and avoid extending the amount of time you're burdened with that mortgage. Of course, this strategy only works if you can actually afford a larger monthly payment. (Remember, while you'll benefit from a lower interest rate, your actual payment will still be higher if you switch from a 30-year to a 15-year mortgage.) But if your earnings have increased substantially since you first signed your mortgage and you have room in your budget for higher monthly payments, you'll come out ahead in the long run. Figuring out what decision is right for you can be as simple as doing some back of the envelope math so take the time to crunch the numbers because it can quite literally save you thousands of dollars.
So hopefully all this was a good primer on the world of credit and its main forms both in professional finance and in our everyday lives. We live in a world addicted to credit so understanding what it is and how it works is very important, especially today as we are being forced to reconcile with the untenable amounts of debt within the system. As alluded to in the beginning of this article, our addiction to credit and excessive deficit spending has led interest rates on bonds in many cases to turn negative, meaning investors are paying the bond issuer to borrow their money. This can and should seem ridiculous, but there are two main points to clarify why this is even a possibility and why any investor would ever sign on for such a thing. First, the reason investors tolerate this is a negative 1% yield is still better than losing 2-5% from inflation. It may not be ideal, but it’s the lesser of two evils if you are deciding between cash and bonds or just want a predicable return (albeit a negative return) in the face of risk. Second, the reason this is happening is because governments, which are the bond issuers who will occasionally have negative yielding bonds, are attempting to inflate their debt away. Negative interest rates mean their debts are decreasing, which is slowly becoming a necessity with how much debt many nations, including the United Sates, have. To do this, though, rates don’t have to actually be negative, they just have to be lower than the rate of inflation. They can be nominally positive at, say, 2%, but be fighting inflation at 3% making their real return negative and, thus, still decreasing the debts of that bond issuer. This is one of the biggest stories in the bond world and worth considering in some detail to piece together what is perhaps the biggest problem economies are facing today. Debt and credit are as helpful as they are dangerous.