Question

Use the market of corporate bonds and government bonds to graphically explain why the credit spread increases when there is a financial crisis.

Answer 1

The uncertain conditions which will result, when there is financial crisis cause investors to invest in more secured and trusted securities like Government bonds. This is also called as Flight-to-safety, where the investors sell risky Corporate bonds and invest the proceeds in Government bonds like U.S. Treasury bonds. Also the difference between the yield of a Corporate bond and an equivalent maturity Government bond is called Credit spread. This spread is a major indicator on how well the market is doing and will do both in present and future times to come. Generally the yields on Corporate bonds are higher to reward investors for taking risk which is related to Credit risk, Liquidity risk and Market risk. The narrowing spread refers that the markets are doing good and widening refers to market's health is not that great. So in a situation like crisis, the selling pressure on Corporate bonds cause them to trade at lower prices there by increase in the yields, and due to high demand for Government bonds they tend to trade at higher prices and the yields fall. This will result in widening of spreads between Government and Corporate bonds in times of crisis. Also when the yield curve of long-term Government securities tend to invert i.e. the graph of yield curve shows the sign of downward trend or sloping downwards, there is a general implied notion in the minds of investors that there are signs of Rescission, due to inversion of yield curve.

I have attached an image of graphs which will give you more clearer picture.