Default rates can fluctuate widely in response to economic conditions.

Therefore, a key question for investors is, do credit spreads reflect these fluctuations in default rates? The answer, as we can see from this chart is yes.

Credit spreads tend to widen during periods when default rates are high signaling increased perceived risk in the market.

So what exactly are we looking at here? This chart tracks the option adjusted spreads for various credit ratings over time.

The option adjusted spread, or OAS represents the yield spread adjusted for any embedded options in the bonds, such as for callable or convertible bonds, giving us a clear review of the underlying credit risk without the influence of the optional features.

We have three lines representing different indexes.

The green line at the top represents the ICE BofA, triple C and lower US high yield index, which includes bonds rated triple C or lower.

This line exhibits the most volatility showing substantial spikes in times of economic stress reflecting the higher risk of default moving down.

The lighter blue line represents the ICE BofA Triple B US corporate index.

Triple B rated bonds are at the lower end of investment grade, just one notch above high yield.

While these bonds are less risky than triple C rated bonds, they still show some sensitivity to market conditions with moderate spread increases during periods of economic instability.

Finally, the dark blue line represents the ICE BofA triple A, US corporate index.

AAA rated bonds are considered the safest corporate bonds due to their high credit quality.

They experience very little movement in spread even during times of economic stress.

While it may seem like there's almost no movement, any subtle shifts we see in this line still reflect the market's response to economic changes.

Although due to the charts scaling, these shifts may look minor.

As you might expect, the investment grade spreads represented by the triple A and triple B lines are generally much lower than those for high yield bonds the triple C line. This reflects the lower risk associated with higher credit quality bonds.

Although it's essential to note that even investment grade spreads are not completely immune to market fluctuations. We also see that spreads for high yield bonds, particularly those rated triple C and lower, respond Significantly during periods of economic downturns.

These peaks aligned with historical economic crises such as the global financial crisis in 2008, the COVID-19 pandemic in 2020, and other periods of market stress.

Each of these events led to increased perceived risk resulting in wider spreads for riskier bonds.