Backstory: Default risk premiums are interpreted as the probability of a borrowe
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Backstory: Default risk premiums are interpreted as the probability of a borrower missing an interest payment or principal repayment. We generally conclude that US Treasury bonds are default risk free because the US government has never missed an interest or principal payment. Thus, we can estimate the default risk premium by taking the difference between the yield on a bond from an issuer that is not the US government, such as a domestic or foreign company, and the yield on a US Treasury bond with a similar maturity. (Note: Default risk means the same thing as credit risk, which means default spreads and credit spreads may be used interchangeably).
Financial theories find that the quality of a borrower’s balance sheet indicates the amount of access it will have to external financing (e.g., bank loans, public bonds, or equity). This implies that changes in default (or credit) spreads provide information on how strong a company’s balance sheet is.
Additionally, credit spreads may change based on the balance sheets of financial intermediaries. When the balance sheet of a financial intermediary deteriorates, perhaps because of increases in late loan payments from borrowers, the supply of credit extended in the economy is reduced. Reducing the amount of credit available in the economy causes credit spreads to widen.
The question to answer: The article discusses increases in credit spreads at the onset of the COVID-19 pandemic in the US. Do you think the widening of credit spreads was mainly a result of increased corporate default risk or a reduction in credit supply from financial intermediaries due to an increase in expected delinquencies?