Question

Use the government bond market and corporate bond market to show why the credit spread (defined as corporate bonds yields minus government bonds yields) would increase when financial risk becomes higher.

Answer 1

When financial risk increases, default risk for corporate bonds increases. Higher default risk risk will increase the yield for corporate bonds. Credit spread being difference in yield of a corporate bond and yield on similar government bond, higher yield on corporate bond will increase 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

Higher default risk lowers the demand for corporate bonds, shifting corporate bond demand curve to left, lowering their price and quantity. Bond price and interest rate (yield) being inversely 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.

So A Po Do DI

(2) Government bond market

Higher risk of default for corporate bonds increases demand for government bonds, shifting government bond demand curve to right, increasing their price and quantity. Bond price and interest rate (yield) being inversely 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.

50 A DI Po Do

So, higher yield of corporate bond and lower yield of government bond collectively increase the credit spread.