Explain how credit spreads, and returns on credit-sensitive fixed-income securities, shift as the business cycle moves through its stages

Credit spreads compensate for expected default losses, for the risk that they rise in bad times, and partly for illiquidity. They widen as a recession approaches and during it, as expected defaults and risk aversion rise together, and they narrow through recovery and expansion. Lower-rated issuers are the most sensitive, so high-yield spreads widen by far more in basis points than investment-grade spreads, and credit-sensitive bonds underperform government bonds of similar duration in downturns but outperform in recoveries. The price effect of a spread change is roughly minus spread duration times the change in spread. The trap is assuming that because government yields fall in a recession, corporate bond prices must rise too, when spread widening can more than offset the rate effect.