Series 7: 9.1.2.3 Credit Spreads

9.1.2.3  Credit Spreads

Investors expect to be paid to take risk, and a bond with a low credit rating is riskier than an identical bond with a higher credit rating. This is reflected in the bond’s credit spread, which is the difference between the bond’s yield and the yield of a low-risk benchmark, such as a Treasury. A non-investment-grade junk bond, for example, will command a higher credit spread than a high-quality general obligation municipal bond.

Because bond yields are constantly changing, so are their spreads. Credit spreads can “widen,” meaning that the yield difference between a bond and its benchmark increases. Spreads widen during contractionary periods of the business cycle and narrow during periods of expansion. In prosperous times, businesses thrive, and the risk of default among even the lowest rated bonds is perceived to be small. High demand for