Credit Risk Management Practice Exam

What happens to credit spreads as the time to maturity increases?

1. They tend to narrow

2. They remain constant

3. They often widen

4. They improve drastically

The correct answer is: They often widen

As the time to maturity increases, credit spreads often widen due to several factors that contribute to the risk associated with longer-term investments. Longer maturities typically expose investors to greater uncertainties regarding the issuer's creditworthiness over that extended timeframe. These uncertainties can stem from various elements such as economic conditions, interest rate fluctuations, and changes in the issuer's financial health, all of which may fluctuate unpredictably over time. In addition, as the maturity period extends, investors require a higher return for the additional risk they are taking on. This demand for higher yields results in wider credit spreads, reflecting the premium investors seek for the increased exposure to credit risk. Generally, the longer the maturity, the higher the perceived risk, hence leading to a widening of credit spreads. Shorter maturities tend to have narrower spreads as the risks are comparatively lower, which is not the case for longer-term bonds. This dynamic is a critical aspect of credit risk management, as it helps investors gauge potential losses over time and make informed decisions regarding credit investments.