Credit spread is the difference in yield between two bonds of similar duration (maturity), but different credit qualities. Government bonds are backed by sovereign guarantee and therefore, have no credit risk. Corporate bonds, on the other hand, have credit risks and hence, offer higher yields.
Difference in yields between Government bonds and corporate bonds is credit spread. Lower the rating of corporate bonds, higher is the credit spread. Widening or narrowing credit spreads have implications for capital markets. Widening credit spreads imply that investor demand for safer Government bonds is higher. When demand for Government bonds is higher, the prices of Government bonds rise and this causes their yields to fall, resulting in wider credit spreads. Widening credit spreads imply that investors are uncertain about the economy and the ability of companies in servicing their debt obligations. This has implications for the debt markets and perhaps also, the equity markets. Narrowing credit spreads, on the other hand, signal confidence in the economy and is positive for the market.
