Credit Spreads

Sorry, I know this should be a really simple concept but it’s late and I can’t think straight…

But why do credit spreads widen during an economic contraction? I would have thought that the flight to safety (i.e., bonds) during a contraction would drive prices up and push interest rates down thereby narrowing the spread? What am I missing here?


What happens during an economic contraction?

Everyone dumps corporates and buys Treasuries.

When everyone dumps corporates, what happens to the prices of corporate bonds?

They decrease.

And their yields?

They increase.

When everyone buys Treasuries, what happens to the prices of Treasuries?

They increase.

And their yields?

They decrease.

So, increased yields on corporates and decreased yields on Treasuries means that corporate yield spreads have widened.


makes sense! smiley

That happens sometimes. Purely accidentally.

You can also draw out 2 horizontal paralleil lines with the reasonings Mr. Magician just explained above to visualize this. The above line is corporate yield, the below one is treasury yield. The two lines get closer when economy is in expansion (corporate bond yield goes down because high demand drives its price up, treasury bond yield goes up because low demand drives its price down). And vice versa.

I remember the effect just by doing so and that’s what I learnt from a video by Mr. Arif Irfanullah on youtube :).