What happens to spreads during a recession?

During a recession, spreads tend to widen. This occurs because the perceived risk of default increases as economic conditions deteriorate. Investors become more risk-averse, leading to a flight to quality, where they prefer safer assets such as government bonds over riskier assets like corporate bonds. As a result, the yields on corporate bonds increase to compensate for the higher risk, leading to wider spreads compared to the yields on safer government securities.

Additionally, during a recession, corporations may face lower revenues and higher probabilities of default, which can further exacerbate the widening of spreads. Credit markets might also see reduced liquidity, as market participants are less willing to buy riskier assets, contributing to the widening spread dynamics.

In contrast, spreads tightening would indicate an improvement in creditworthiness or economic conditions, which is typically not observed during a recession. Stable spreads would suggest that market perceptions remain unchanged, contrary to the heightened uncertainty in a downturn. The disappearance of spreads would imply that there is no differentiation between credit risks, an unrealistic scenario during economic hardship.