The higher the credit risk, the greater the required yield and potential return demanded by investors. Over time, bonds with more credit risk offer higher returns but with greater volatility of return than bonds with lower credit risk.

Yield spread is the difference in yield between two securities.

• The yield of a corporate bond = yield on a risk-free bond + yield spread
• The yield spread here is composed of the liquidity premium and the credit spread: yield spread = liquidity premium + credit spread

Macroeconomic, market and issuer-specific factors impact yield spreads.

Macroeconomic Factors. Yield spreads, especially credit spreads, become wider during economic contractions. In times of credit improvement or stability, however, credit spreads can narrow sharply as well. This is known as "flight to quality".

Since bonds primarily trade over the counter, investors require broker-dealers' willingness to provide sufficient capital for market-making. When there is financial and regulatory stress, it may cause a reduction in capital available for market-making and willingness to buy or sell bonds with credit risk. Low funding availability will cause wider spreads.

Market factors include market making capacity, and supply/demand conditions and market liquidity risk. For example, the less debt an issuer has outstanding and the less frequently its debt trades, the higher the market liquidity risk and the bid-ask spread.

Issuer-specific factors include the issuer's debt coverage, leverage and earnings news. For example, favorable news increases the demand for the issuer's bonds, narrowing the credit spread. Bad news intuitively widens the credit spread.

The Price Impact of Spread Changes

How do spread changes affect the price of and return on these bonds? The impact depends on two factors:

• The basis point spread change
• The sensitivity of price to yield as reflected by modified duration and convexity

A credit curve is essentially the spread over treasuries of various maturities for a single bond issuer. It is typically upward-sloping, meaning the longer the bond maturity, the wider the spread.