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.
What is the primary purpose of a credit spread?
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A) A credit spread measures the difference in yield between two bonds with similar maturities but different credit qualities. B) Duration measures a bond's price sensitivity to changes in interest rates. C) Liquidity risk assesses the risk that an investor cannot sell a bond at a fair price. D) Call risk evaluates the risk that a bond will be called before its maturity date.
Which of the following risks is most directly related to credit spread?
A) Interest rate risk is related to changes in interest rates, not credit spread. B) Reinvestment risk is related to reinvesting cash flows from a bond, not credit spread. C) Spread risk is the risk that the credit spread will widen, causing the price of a bond to decline. D) Call risk is related to the possibility of a bond being called before its maturity date, not credit spread.
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.
If the credit spread between two bonds with similar maturities increases, what is likely to happen to the price of the lower-rated bond?
A) An increase in credit spread indicates that investors demand a higher yield for the lower-rated bond, which would cause the price to decrease. B) A decrease in price results from an increase in credit spread. C) The price will likely change if the credit spread increases. D) The price may become more volatile, but the primary effect of an increase in credit spread is a price decrease.
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.
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Example Series 65 Example Practice Question
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.
- *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.
- *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.