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The credit spread on a corporate bond is computed as the difference between the yield to maturity on a corporate bond and the corresponding maturity risk-free rate (government bond yield).1 The spread is determined to a large extent by the default risk of a bond, where default risk is the uncertainty surrounding a firm's ability to service its debt and obligations. While corporations are subject to default risk, it is generally assumed that the default risk on corresponding dollardenominated Treasury bonds is zero. Thus, we should expect that corporate bonds should always yield more than Treasury bonds or that the credit spread should be positive because arbitrageurs could exploit this discrepancy. In theory, if the prices of two assets diverge (corporate bond prices are higher than they should be relative to Treasury bonds), market participants will short-sell the more expensive asset (corporate bond) and purchase the less expensive one (Treasury bond with equivalent maturity) and, as a result, make a sure profit without making any investment, and without taking any risk. Recent articles in the financial press, however, point to many instances where reported spreads are negative. For example, Exhibit 1 shows that the credit spread of an American Express bond dipped into negative territory on three occasions (in the oval section). Reflecting these observations, a recent article in Bloomberg states:
The bond market is saying that it's safer to lend to Warren Buffett than Barack Obama. Two-year notes sold by the billionaire's Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe's Cos. debt also traded at lower yields in recent weeks.2
Given the increase in the federal deficit as well as the large pools of money (e.g., hedge funds) chasing opportunities in the financial markets, these deviations have attracted the attention of politicians and market participants alike. What may cause negative spreads? One explanation is that market participants indeed believe that the possibility of default for Treasury debt was higher than that for these corporate bonds at that time. A second explanation is that the negative spreads are caused by temporary liquidity factors and are not economically...