Markets are interrelated. Just keep that in mind during this entire explainer and you’ll see how credit impacts equity.
First, holding equity in a company means owning a portion of its residual value. Holding a company’s credit means owning its bonds or, in other words, its promises to pay its debt back to its lenders.
However, this isn't like holding a government bond. With credit, investors demand a risk premium, so a higher yield than treasuries.
Corporate credit has a far higher likelihood of defaulting than government debt has. And debt is paid to bond holders before we account for what’s available for equity holders.
Therefore, the price a bond investor is willing to pay to own a company’s debt is going to drop when the creditworthiness worsens. The price will rise when the earnings stream looks more than sufficient for debt repayment.
So when the price of riskier corporate bonds falls, it indicates that the company’s earnings stream could be lower than previously expected. If bondholders with those first claims on assets are worried, then the stock holders would be worried too.
Importantly, credit markets are slightly less widely covered by data hubs, researchers, and news outlets, but they can often be a good indication of where stocks are headed.
Historically, when credit markets show stress, that can precede stress in the stock market. When credit markets show confidence, that can be a positive signal for stocks.
To see how this could impact your stocks, watch the quick video above.