All about assets: credit

To end his series, Will Hodges looks at how one party's debt can become another's asset

What is credit?

Credit, also known as debt, comes in many different shapes and sizes. What it essentially boils down to, however, is a lending agreement between two parties: a debtor (borrower) and a creditor (lender). One or more creditors will enter into a contract with a debtor under which the debtor will borrow money in return for interest. In the financial world, this agreement can be packaged up into an easily tradeable financial asset known as a bond, which offers a fixed rate of interest over a given period and will come with a fixed set of rules regarding repayment. Bonds can be issued by governments (government bonds) and companies (corporate bonds).

What's all the fuss about?

Credit has become an ever more integral part of the global financial landscape. Across the world, the market for bonds and other debt-related products such as credit derivatives grows alongside the expansion of the global economy. Western investors now have unparalleled access to bond issuances from companies and governments from Asia, Africa and South America, as well as European and US bonds. New emerging market debtors often offer a much higher rate of interest than their European or US counterparts in compensation for their relative lack of track record as reliable repayers of debt.

Who invests in credit?

The majority of bond market investors in Europe are institutional investors such as pension funds, insurance companies and banks. Individuals account for about 5 per cent of the market across the continent, although in the UK this figure is less than 2 per cent. Individual investors in bonds are often characterised as "Belgian dentists" - wealthy professionals who dislike taking risks with their money.

What are the advantages of investing in credit?

Credit represents one of the safer and most reliable vehicles for financial investment. As the stock market has endured one of the rockiest periods for generations, bonds have proved (for the most part at least) something of a safe haven for many investors, offering a stable run of return and relatively little risk. The bonds of a reliable debtor with a good track record of repayments are likely to provide a solid investment. US government bonds (known as T-Bills) are often regarded as one of the most secure forms of investment in existence and have traditionally provided a return of about 3 per cent. At the opposite end of the scale, a debtor with a shaky credit history may offer a much higher rate of return, but investors will have to accept the risk that their interest and repayment money may come late, or not at all.

The one major advantage creditors have over equity holders is a legal right to repayment. If a company is in financial distress and facing liquidation, creditors get priority access to the company's remaining assets, if any, and shareholders have to wait for them to pick over the carcass before getting a chance to recoup their investment.

What are the disadvantages of investing in credit?

While certainly one of the more reliable forms of investment, the relatively meagre returns offered by "safer" debt products such as government bonds risk being eroded through inflation. For instance, a bond paying a return of 3 per cent a year becomes essentially worthless if the rate of inflation is equal or higher. In such circumstances, investors may be better off keeping money in a high-interest savings account where the level of risk is virtually zero.

Credit is by no means a risk-free asset, however, with recent economic events undermining the reputation of a number of supposedly safe government and corporate debtors. In Europe, Greece, Italy and Portugal have struggled to meet repayments to their creditors, resulting in widespread panic among investors which has even threatened to break up the European Union. The US, for several decades considered the world's most reliable issuer of government bonds, has had its creditworthiness called into question having suffered a downgrade on its credit rating in summer 2011. On the corporate side, massive American car company General Motors, whose bonds were considered for generations to be some of the safest around, went into a bankruptcy and bailout process in 2009, leading to massive bondholder losses.

Where could I fit in?

With London increasingly recognised as the world's leading financial centre, there are ample opportunity for UK graduates interested in credit investments. Here are just some of the possibilities:

  • Credit analyst at a bank or investment firm
  • Bonds trader at an investment bank, brokerage firm or hedge fund
  • Bonds salesperson at an investment bank or brokerage
  • Credit analyst with a financial research firm or ratings agency
  • Bank finance lawyer.