The default spread is typically larger when business conditions are poor, i.e., a greater probability of default by the borrower.
OK- No issues here
The positive sign for default spread indicates that expected returns are positively related to default spreads, meaning that excess returns are greater when business conditions are poor.
Can some one explain this, specially underlined area?
for instance, say business fails to pay interest payments on debt (i.e buz defaults on payments) Also, at the same time business wants to raise funds from markets (say by debt mrkt) to support its operations. now what the investor will say that, buz conditions are poor at this time, so we are actually taking more risk by lending u funds…hence, they demand excess returns for the per unit of excess risk they are taking. As default risk increases…expected returns increases(bcoz investors are taking more risk)
Essentially when business is bad risk taking is avoided. To intice investors to finance debt, issuers have to raise the rate of their issue.
The opposite is true when business is good. Risk taking is up, yields are down. We see this today between the HY bonds and investment grade, the spread has narrowed significantly since 2009.