7.3.4. Credit Spreads
A yield spread is the difference between the yield curves of two different kinds of bonds. Yield spreads may be due to differences between credit ratings, maturities, and market sectors. A credit spread is the difference between the yield of a riskless Treasury bond and a security with credit risk (such as a municipal or corporate bond) that are identical in all other respects except credit quality. In this instance, the riskless Treasury bond is known as a benchmark. At their essence, credit spreads are a risk premium.
In general, a bond’s yield can be expected to increase as its risk increases, and its credit yield spread, relative to Treasuries, must increase as well. Investors expect to be paid to take risk. A junk bond, for example, will command a higher yield than a high quality general obligation municipal bond, and it will have a higher spread.
Because bond yields are constantly changing, so are their spreads. Credit spreads can “widen,”