What best describes a credit spread?

• A. A spread added to government yields for risk
• B. The spread between bid and ask price on a bond
• C. The spread between coupon payments
• D. The spread of inflation

Answer: (D)

Credit spread is the extra yield investors require to compensate for the credit risk of a bond issuer relative to a risk-free government bond of the same maturity. This premium is added to government yields and is typically quoted in basis points. For example, if a 7-year government bond yields 2% and a 7-year corporate bond yields 4.5%, the credit spread is 2.5 percentage points (250 basis points). The spread captures default risk, liquidity, and other credit factors, and it tends to widen when issuer credit quality worsens or risk appetite decreases, and narrow when conditions improve. It is not the difference between bid and ask prices, not the gap between coupon payments, and not a measure of inflation.