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

First let us understand what is credit spread. Definition is : A credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality.

It is clear that when there is financial crisis people will trust treasury bonds more and other corporate bonds might not have buyers. Panic among customers may lead to sell of these bonds and returns will decrease. On the contrary treasury binds will be sold at higher prices du to right shift in demand.

This will lead to difference in returns that treasury bonds and corporate bonds offer. This will increase credit spread as difference increases in terms of returns.

As shown in the fig below. increase in demand for bonds raises its price. Increase in supply of corporate bonds decreases its price.