Suppose the U.S economy is undergoing a severe recession. This means that credit become crunched, investors...

Suppose the U.S economy is undergoing a severe recession. This means that credit become crunched, investors become more risk-averse, corporate liquidity deteriorates, banks are not willing to lend, etc. If this is true, credit spread of any given bond should become narrowed (instead of becoming widened). True or false. Explain.

Expert Solution

Credit spread is the gap between returns of two alternative investments having different credit Qualities(Risk), usually having the same maturity.

Generally
1. Credit spread is narrow during normal/good times (that is when investors sentiment are good).

Because investors are ready to take the risk during good market sentiment for a less increase in return.
Hence narrowing the credit spread.

2. Credit spread is widened during recessions (that is when investors sentiment are bad to worst).

Whereas during recessions the investors become very much risk-averse hence they would want a much higher return for a little increase in risk.
This results in credit spread becoming widened.

Answer: False.

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