During a financial crisis, Treasury yields fall sharply while investment-grade corporate bond yields rise. What best explains the dramatic widening of credit spreads?
ACorporate bonds pay fixed coupons, so their yields automatically rise when interest rates fall
BDefault risk, liquidity risk, and risk aversion all rise simultaneously while Treasuries rally on flight-to-quality demand
CCredit rating agencies downgrade all corporate bonds simultaneously, mechanically increasing their yields
DThe Federal Reserve raises interest rates during crises, increasing borrowing costs for corporations
Spread widening in crises comes from multiple forces acting together: expected defaults rise, liquidity dries up (markets thin out, bid-ask spreads widen), and risk aversion surges. At the same time, Treasuries rally as investors flee to safety — yields fall. The spread widens from both ends. Rating downgrades may follow, but they react to market conditions rather than drive them.
Question 2 Multiple Choice
A corporate bond yields 5.5% while a Treasury bond of the same maturity yields 4.0%. The 150 bps credit spread primarily represents:
APurely the expected annual default loss — the probability of default times the loss given default
BCompensation only for liquidity risk, since investment-grade bonds rarely default
CCompensation for default risk, liquidity risk, and credit cycle risk — more than expected default losses alone can explain
DThe coupon premium paid to attract investors who prefer corporate bonds over Treasuries
Credit spreads decompose into a default risk premium and a liquidity premium, and empirical research finds that actual expected default losses alone substantially underexplain observed spreads. Liquidity risk and credit cycle compensation account for a large share — more than naive default probability calculations would predict. Even investment-grade bonds carry meaningful liquidity risk.
Question 3 True / False
Credit spreads on corporate bonds tend to widen during economic expansions and narrow during recessions.
TTrue
FFalse
Answer: False
The opposite is true. Spreads NARROW in expansions (defaults are rare, investors are risk-hungry and willing to accept less compensation) and WIDEN in recessions (defaults spike, liquidity dries up, risk aversion surges). This cyclical pattern means corporate bonds perform worst precisely when economic conditions are most painful — a key source of credit risk distinct from interest rate risk.
Question 4 True / False
A high-yield (BB-rated) bond typically carries a wider credit spread than an investment-grade (BBB-rated) bond because it carries higher default probability and lower liquidity.
TTrue
FFalse
Answer: True
Credit ratings signal default risk, and higher default risk (plus lower liquidity) commands a wider spread. High-yield bonds historically carry spreads of 300–1000+ bps compared to 50–300 bps for investment-grade bonds, reflecting meaningfully higher expected default rates and thinner markets. During the 2008–09 crisis, high-yield spreads exceeded 2,000 bps.
Question 5 Short Answer
Why might a corporate bond's credit spread be larger than what expected default losses alone would predict? What other risks does the spread compensate investors for?
Think about your answer, then reveal below.
Model answer: Beyond default risk, the spread compensates for liquidity risk — the difficulty of selling the bond quickly at fair value, especially in stressed markets — and for credit cycle risk: the mark-to-market losses from spread widening during downturns, even if the bond ultimately doesn't default. Empirical studies find that expected default losses alone account for less than half of observed spreads in many market conditions; the rest reflects liquidity premiums and compensation for bearing credit cycle volatility.
This distinction matters for portfolio management: investors who focus only on default probability will underestimate the true risk of corporate bond holdings. Spread widening can cause substantial losses long before any actual default occurs.