Why is the credit spread countercyclical and coincident?
What will be an ideal response?
The credit spread is the interest rate on corporate bonds minus the interest rate on government bonds. Since the bonds are long term in each case, they are not affected directly by short-term fluctuations. However, during the expansion phase of the business cycle, corporate profits and other indicators of financial strength at many businesses imply a low risk of default on corporate bonds, so their cost of borrowing (interest rate on the bond) declines. During the contraction phase of the cycle, the risk of corporate default is higher for many businesses, so borrowing is more costly (higher interest rate on the bond). Since the perceived zero default risk on government bonds is unaffected by the business cycle, the varying interest rate on corporate bonds causes the spread to move countercyclically. The change in the spread is coincident to the business cycle, because it reflects the impact of current economic conditions on business financials.
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