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

When there is a financial crisis, risk of default rises for corporate bonds. Increase in risk will increase the yield for corporate bonds. Since Credit spread is the difference in yield of a corporate bond and government bonds, higher yield on corporate bond increases credit spread.

In following graphs, D0 and S0 are initial demand and supply curve for bonds, intersecting at point A with initial price P0 and quantity Q0.

(1) Market for Corporate bond

Increased risk of default reduces the demand for corporate bonds, shifting corporate bond demand curve to left, lowering their price and quantity. Bond price and interest rate (yield) being negatively related, reduction in bond price will increase interest rate (yield) of corporate bonds. In following graph, as demand decreases, D0 shifts left to D1, intersecting S0 at point B with lower price P1 and lower quantity Q1.

(2) Treasury bond market

Higher risk of default for corporate bonds raises the demand for government bonds, a substitute for corporate bonds with zero default risk, shifting government bond demand curve to right, increasing their price and quantity. Bond price and interest rate (yield) being negatively related, increase in bond price will increase interest rate (yield) of government bonds. In following graph, as demand increases, D0 shifts right to D1, intersecting S0 at point B with higher price P1 and higher quantity Q1.

Hence, an increase in yield of corporate bond and decrease in yield of government bond together increase the credit spread.