A corporate bond is trading at a 150 basis point spread over Treasuries. The Federal Reserve then holds interest rates constant, but the issuing company's earnings collapse and analysts downgrade its credit rating. What most likely happens to the corporate bond's price?
AThe bond price stays the same because interest rates didn't change
BThe bond price rises because lower earnings reduce future coupon payments
CThe bond price falls because the wider credit spread raises the required yield
DThe bond price is unaffected until the company actually misses a coupon payment
Credit risk and interest rate risk are separate drivers of bond prices. When the market reassesses an issuer's creditworthiness downward, investors demand a higher yield to hold the bond — the credit spread widens. Since bond price and yield move inversely, a higher required yield means a lower price, even with rates unchanged. This is credit risk in action: the bond's price fell purely because the market's estimate of default probability (and uncertainty around it) increased. Option A is the most common misconception — equating bond price changes exclusively with rate moves.
Question 2 Multiple Choice
Which of the following best explains why a bond widely expected to be repaid in full still trades at a positive credit spread over Treasuries?
ABond investors always demand a spread to compensate for inflation risk
BInvestors require compensation for the *uncertainty* of that outcome, even if default is unlikely
CCorporate bonds have longer maturities than government bonds, so the spread compensates for duration
DRegulatory requirements force institutional investors to charge a minimum spread on all non-government bonds
Even a bond with very low default probability carries a risk premium for uncertainty — the chance that the expected outcome doesn't materialize. The credit spread has three components: expected default probability, expected loss given default, and a risk premium for bearing that uncertainty. Investors can't perfectly predict outcomes, and uncertainty itself has a price. A government bond is treated as risk-free because the sovereign can print currency; a corporate bond cannot make that guarantee, so some compensation for the non-zero (even if tiny) possibility of loss is always required.
Question 3 True / False
A credit spread of 120 basis points means the corporate bond's yield includes 1.20 percentage points of compensation that reflects mainly the market's estimate of the probability the issuer will default.
TTrue
FFalse
Answer: False
The credit spread captures three distinct components, not just default probability alone. It includes: (1) the expected default probability, (2) the expected loss given default — how much investors recover if default occurs, since bonds often recover 30-60 cents on the dollar — and (3) a risk premium for the *uncertainty* of those estimates. A bond with a 1% expected annual default probability and 50% expected recovery rate would not trade at exactly 50 basis points; it would trade wider because investors demand extra compensation for bearing the risk that their estimates are wrong. The spread is thus larger than a pure actuarial calculation would suggest.
Question 4 True / False
Credit spreads tend to widen during recessions and narrow during economic expansions.
TTrue
FFalse
Answer: True
This reflects the fundamental connection between economic conditions and credit risk. During recessions, corporate revenues fall, default rates rise, and investors become more risk-averse — they demand greater compensation for holding risky assets and often sell corporate bonds to buy safe government bonds ('flight to quality'). Both effects push spreads wider: higher required yield + lower corporate bond prices. During expansions, the reverse occurs: strong earnings reduce default probability, investor confidence rises, and demand for corporate bonds compresses spreads. The 2008 financial crisis is the extreme example, with investment-grade spreads widening from ~100 basis points to 500+ in months.
Question 5 Short Answer
Explain the difference between interest rate risk and credit risk as drivers of bond price changes, and why understanding both is essential for fixed income analysis.
Think about your answer, then reveal below.
Model answer: Interest rate risk is the risk that benchmark rates (like Treasury yields) rise, mechanically reducing all bond prices because future cash flows are discounted more heavily. Credit risk is the risk that the specific issuer's ability or willingness to repay deteriorates, causing the credit spread to widen and the bond's yield to rise independently of any benchmark move. A bond's total yield is approximately the risk-free rate plus the credit spread. If rates rise, nearly all bonds fall in price together. If an issuer's credit quality deteriorates, only that issuer's bonds fall — the spread widens while comparable Treasury yields are unchanged.
Fixed income investors must decompose yield into these two components because they require different management strategies. Interest rate risk is hedged through duration management (holding shorter-maturity bonds or using rate swaps). Credit risk is managed through credit analysis, diversification across issuers, and sometimes credit default swaps. A portfolio manager who confuses the two might hedge against rate moves while ignoring a deteriorating credit, or vice versa — resulting in losses from a risk they thought they had controlled.