Lesson

Credit spread is the difference in yield between two bonds with similar maturities but different credit quality. It measures the additional yield an investor demands for taking on the credit risk associated with a lower-rated bond compared to a higher-rated bond.

Practice Question #1

What is the primary purpose of a credit spread?

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Terms

Credit Spread:
The difference in yield between two bonds with similar maturities but different credit quality.
Credit Risk:
The risk that a borrower will default on their debt obligations.
Risk Premium:
The additional yield an investor demands for taking on the credit risk associated with a lower-rated bond compared to a higher-rated bond.
Spread Risk:
The risk that the credit spread will widen, causing the price of a bond to decline.

Practice Question #2

Which of the following risks is most directly related to credit spread?

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Historical Example

In the aftermath of the financial crisis in 2008, credit spreads widened significantly as investors demanded higher yields for taking on the increased credit risk associated with lower-rated bonds. This led to lower bond prices and higher borrowing costs for issuers with lower credit ratings.

Practice Question #3

If the credit spread between two bonds with similar maturities increases, what is likely to happen to the price of the lower-rated bond?

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Real-World Example

Suppose an investor is considering two bonds with similar maturities, one issued by a highly-rated corporation and the other by a lower-rated corporation. The highly-rated bond has a yield of 3%, while the lower-rated bond has a yield of 5%. The credit spread between these two bonds is 2%, representing the additional yield the investor demands for taking on the credit risk associated with the lower-rated bond.

Practice Question #4

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Rhyme

When comparing bonds of different grades, credit spread is the key, It measures the extra yield we need, for taking on more risk, you see.

Practice Question #5

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More Detail

- *Credit spread narrowing*: When the difference between the yield of a corporate bond and a risk-free government bond with the same maturity decreases, making the corporate bond more attractive. - *Credit spread widening*: When the difference between the yield of a corporate bond and a risk-free government bond with the same maturity increases, making the corporate bond less attractive.

Practice Question #6

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More Detail Examples

- *Credit spread risk example*: An investor holds a corporate bond with a yield of 5% and a government bond with a yield of 3%. - *Credit spread narrowing example*: If the credit spread narrows, the corporate bond's yield may decrease to 4%, making it more attractive compared to the government bond; as yields decline, prices increase. - *Credit spread widening example*: If the credit spread widens, the corporate bond's yield may increase to 6%, making it less attractive compared to the government bond; as yields increase, prices decline.

Practice Question #7

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Pitfalls to Remember

- *Credit spread risk pitfall*:
Investors should be aware that credit spread risk can lead to significant changes in the value of their fixed-income investments, especially during periods of economic uncertainty or market volatility.

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