What does a rising credit spread indicate about credit risk and market conditions?

• A. Lower default risk.
• B. Higher perceived default risk or illiquidity, or compensation for risk during stress.
• C. Spreads narrow when risk is high.
• D. Spreads are irrelevant to market conditions.

Answer: (B)

Rising credit spreads reflect investors requiring more compensation for the risk of holding a credit instrument. The spread is the extra yield over a risk-free benchmark that investors demand to account for credit risk and liquidity risk. When the market perceives higher default probability or finds it harder to trade these securities (illiquidity), it pushes yields up relative to government bonds, widening the spread. This also happens during stress, when investors demand even more premium to bear risk. If default risk were actually lower, spreads would tend to shrink, and spreads aren’t irrelevant to market conditions—they move with changes in risk and liquidity in the financial system.