Yield Spread

B is correct. The credit spread widened dramatically from 150 basis points (5.00% - 3.50%) to 400 basis points (6.50% - 2.50%). This widening reflects a classic "flight to quality" during recession: investors sell risky corporate bonds (driving yields up and prices down) and buy safe Treasury bonds (driving yields down and prices up). The 250 bp widening indicates sharply increased default risk concerns and risk aversion.

A is incorrect because the spread widened, not narrowed; calculating 6.50% - 2.50% = 400 bps, not 100 bps. C is incorrect because spreads rarely remain constant during recessions; this scenario shows a 250 bp widening. D is incorrect because credit spreads cannot go negative in normal markets; corporate bonds always carry more risk than Treasuries and must offer higher yields, not lower yields.

B is correct. The yield spread (credit spread) between a corporate bond and a comparable Treasury bond represents the risk premium investors demand for accepting the credit (default) risk of the corporate issuer. Treasury bonds are considered risk-free for credit purposes, so any excess yield on the corporate bond compensates for default risk.

A is partially true (liquidity does factor in) but incomplete; the primary driver is credit risk, not liquidity. C is incorrect because yield spread measures the difference in yields-to-maturity, not coupon rates; bonds can have identical coupons but different yields if priced differently. D is incorrect because corporate bonds have a tax disadvantage (fully taxable) compared to municipal bonds, not Treasuries; both corporate and Treasury interest is federally taxable.

C is correct. Calculate the credit spread: 4.80% - 3.20% = 1.60%. Convert to basis points: 1.60% × 100 = 160 basis points. Since 1 basis point = 0.01% (one-hundredth of a percent), 1.60% equals 160 basis points.

A (80 bps) incorrectly calculates half the spread or confuses the conversion factor. B (120 bps) results from a calculation error, possibly subtracting incorrectly (4.80 - 3.20 = 1.60, not 1.20). D (200 bps) overestimates the spread, perhaps by rounding 1.60% to 2.00%. Remember: to convert percentage points to basis points, multiply by 100 (1% = 100 bps).

D is correct (the EXCEPT answer). Narrowing spreads do NOT necessarily mean corporate bonds are becoming safer in absolute terms; they indicate RELATIVE improvement in creditworthiness compared to Treasuries, or increased investor risk appetite. Spreads can narrow while all bond yields rise (if corporate yields rise less than Treasury yields fall) or while overall credit fundamentals remain weak but market sentiment improves.

A is accurate: during recessions, credit spreads widen as default risk increases and investors flee to quality. B is accurate: wider spreads mean investors demand more compensation (higher yield) for credit risk, indicating higher perceived risk. C is accurate: basis points (1 bp = 0.01%) are the standard unit for measuring spreads because they provide precision for small differences.

C is correct. Statements 1, 2, and 3 are accurate.

Statement 1 is TRUE: Initial spread = 6.00% - 3.50% = 2.50% (250 bps). Final spread = 5.20% - 3.00% = 2.20% (220 bps). The spread narrowed by 30 basis points.

Statement 2 is TRUE: Narrowing credit spreads during economic expansion typically indicate improved investor confidence in corporate creditworthiness and increased risk appetite. Investors are willing to accept less compensation (lower spread) for credit risk.

Statement 3 is TRUE: Bond prices move inversely to yields. When the corporate bond yield fell from 6.00% to 5.20% and the Treasury yield fell from 3.50% to 3.00%, both bonds experienced price increases.

Statement 4 is FALSE: We cannot determine which bond's price increased more without knowing the bonds' durations, coupon rates, and initial prices. While the corporate bond's yield fell more in absolute terms (80 bps vs 50 bps), price changes depend on duration, with longer-duration bonds experiencing larger price changes for a given yield change.