What does credit spread compression refer to?

Credit spread compression refers to a decline in credit spreads over time. This phenomenon occurs when the difference in yield between different types of debt instruments—typically corporate bonds versus government bonds—narrows. It often suggests increasing investor confidence in the credit quality of borrowers as risk premiums decrease.

When investors perceive a lower risk associated with certain securities, they are willing to accept a lower yield compared to safer alternatives, thereby compressing the spread. This can happen in a stable economic environment where default risks are perceived to be minimal, or during a recovery where economic conditions improve.

Other options describe scenarios that do not align with the concept of credit spread compression. For example, an increase in credit spreads would indicate worsening credit conditions or increasing risk, while stability in credit spreads reflects unchanged perceptions rather than compression. The idea of all credit spreads being equal would negate any risk differentiation, which is contrary to the purpose of credit spreads that reflect varying levels of risk between different issuers.