Chartered Financial Analyst (CFA) Practice Exam Level 2

According to the term structure of credit spreads, how does the credit quality affect spreads over time?

1. Better ratings lead to wider spreads

2. Worse ratings lead to wider spreads

3. Spreads remain constant regardless of credit quality

4. Spreads decrease for all bond ratings over time

The correct answer is: Worse ratings lead to wider spreads

The relationship between credit ratings and credit spreads is well-established in finance, particularly within the context of the term structure of credit spreads. As credit quality deteriorates, indicated by worse credit ratings, the risk perceived by investors increases. This heightened risk prompts investors to demand higher yields as compensation for the uncertainty associated with lower-quality debt. Consequently, bonds with worse credit ratings exhibit wider spreads compared to those with better ratings. These wider spreads reflect the additional risk that investors are taking on when lending to entities with weaker credit profiles. This phenomenon can be observed over time; as economic conditions fluctuate, credit quality can change, influencing the spreads accordingly. If a company's financial health worsens, its credit rating may downgrade, resulting in even broader spreads as investors seek to mitigate the risk. Therefore, the correct understanding is that worse ratings lead to wider spreads, illustrating the direct relationship between declining credit quality and increased credit risk premiums in bond pricing.