When the degree of uncertainty about the economy increases, the spread in the promised yield-to-maturity between high and low-rated bonds tends to
A) decrease.
B) increase or decrease depending on the coupon.
C) widen.
D) reverse the sign of the spread.

Question

Quizplus · Accepted Answer

When uncertainty about the economy increases, investors tend to become more cautious, preferring the safety of low-risk bonds such as Treasuries. This makes the demand for high-rated bonds drop, which then causes their yield to increase to attract investors. In contrast, low-rated bonds tend to have a higher risk of default, which makes investors demand a higher yield to compensate for the risk. The increase in demand for low-risk options and the decrease in demand for high-risk options will cause the spread in the yield-to-maturity to widen.

When the Degree of Uncertainty About the Economy Increases, the Spread