What are credit spreads and how do they affect bond valuations?

• A. They are the difference between a bond's yield and its price.
• B. Credit spreads are extra yield over risk-free rate to compensate for credit risk; wider spreads imply higher risk; spreads compress in good times.
• C. They are the difference between current yield and yield to maturity.
• D. Spreads determine the tax treatment of bond income.

Answer: (B)

Credit spreads are the extra yield investors require to hold a bond with credit risk over a risk-free benchmark. The value of a bond comes from its expected cash flows (coupons and principal) being discounted back at the bond’s yield. That yield is essentially the risk-free rate plus a credit spread that compensates for the issuer’s default risk, plus other factors like liquidity. When credit conditions worsen or risk increases, the spread widens, raising the yield and pushing the bond’s price down. When conditions improve and perceived credit risk falls, spreads tighten, yields fall, and prices rise. This interplay is what makes spreads a crucial driver of bond valuations. They are not simply the difference between yield and price, nor the difference between current yield and yield to maturity, and they do not determine tax treatment of bond income.