Credit risk and credit spreads: how default risk is priced into bond markets
Credit risk is the possibility that a bond issuer will fail to make the promised coupon payments or return the principal at maturity. Investors who take on credit risk demand compensation in the form of a higher yield relative to a comparable government bond—the credit spread. Understanding credit spreads and how they behave across economic cycles is essential for fixed income investors who hold anything beyond the most senior government debt.
What credit risk is
Not all borrowers are equally likely to repay their debts. Governments of strong sovereign nations—the United States, Germany, Switzerland—are considered essentially default-free for debt denominated in their own currency, because they control the money supply. Corporations, lower-rated sovereigns, and sub-sovereign borrowers carry a real possibility of default, which makes their bonds riskier than government bonds of comparable maturity.
Credit rating agencies—S&P, Moody's, and Fitch being the three most widely used—assess and publish credit ratings for bond issuers. Investment-grade bonds are those rated BBB− or above (S&P scale); below this threshold begins the high-yield or speculative-grade universe, also called junk bonds. The distinction matters because many institutional investors are mandated to hold only investment-grade bonds, creating a structural demand difference between the two categories.
How credit spreads work
The credit spread is the difference in yield to maturity between a corporate bond and a government bond of similar maturity. If a five-year US Treasury yields 4.0% and a five-year investment-grade corporate bond of the same maturity yields 4.80%, the credit spread is 80 basis points. This 80 basis points is the compensation demanded by the market for bearing the additional credit risk of the corporate issuer relative to the government.
Credit spreads are not static. They widen during periods of economic stress—when default probabilities rise, liquidity in corporate bond markets declines, and investors demand more compensation for holding credit risk. They narrow during periods of economic expansion and strong corporate earnings—when default risks are low and investor confidence is high. This cyclical behaviour means that corporate bonds have a partial equity-like character: they tend to perform well in the same conditions that favour equities and perform poorly in risk-off episodes.
The total yield on a corporate bond can be decomposed into three parts: the risk-free rate (the government bond yield), the credit spread (compensation for expected default losses), and the liquidity premium (compensation for lower secondary market liquidity compared to government bonds). For investment-grade bonds, the liquidity premium is small; for high-yield bonds and those of smaller issuers, it can be significant.
What the evidence shows
Historical data on credit spreads shows clear cyclicality. US investment-grade corporate spreads—as measured by the ICE BofA Investment Grade Index—averaged approximately 100–150 basis points over the period 2000–2023, but ranged from lows of 50–70 basis points at market peaks to highs of 600 basis points (investment-grade) during the 2008–2009 financial crisis. High-yield spreads showed even wider swings, reaching over 2,000 basis points in early 2009.
Research on the relationship between credit spreads and subsequent returns has found that investing in corporate bonds when spreads are wide tends to produce better returns than investing when spreads are narrow, consistent with the view that wide spreads overcompensate for actual default losses. Studies covering 1990–2020 found that high-yield bonds purchased when spreads exceeded 800 basis points delivered substantially higher subsequent five-year returns than when purchased at spreads below 400 basis points.
Limitations and trade-offs
Credit ratings are backward-looking and slow to adjust. Rating agencies typically downgrade bonds after credit quality has already deteriorated, meaning that the spread on a bond may already have widened significantly before a formal downgrade is announced. Investors who rely solely on ratings to screen credit risk may be behind the market's assessment of deteriorating credit quality.
Corporate bond markets are less liquid than government bond markets. The bid-ask spread on individual corporate bonds can be wide, particularly for smaller issuers and lower-rated bonds. In a period of market stress, corporate bond liquidity can deteriorate sharply, making it difficult to exit positions at acceptable prices. This liquidity risk is embedded in corporate bond spreads but is not always fully captured by credit ratings.
Credit risk in pfolio
pfolio's fixed income universe includes both government bond ETFs and corporate bond ETFs, allowing investors to choose their desired level of credit risk exposure. Government bond ETFs contribute diversification and stability; corporate bond ETFs offer higher yield at the cost of partial equity-like risk in downturns. Fixed income assets available in pfolio, spanning a range of credit qualities, are listed in the Assets section. Fixed income performance and allocation details are tracked in pfolio Insights.
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