Explain the risks a manager must weigh when running a portfolio whose returns hinge on credit spreads

Spread-based portfolios earn excess return over government bonds but carry credit risk in two forms: default risk (probability of default × loss given default) and spread risk, the price loss when spreads widen, measured by spread duration. Over one year, expected excess return ≈ spread − (spread duration × change in spread) − (probability of default × loss given default). Liquidity risk appears as wider bid–ask spreads in stress. Spreads also move together: they widen in recessions just as defaults and illiquidity rise. Lower-rated bonds show larger spread changes in basis points, so exposure is often measured with duration times spread (DTS). The trap is focusing on default alone; for investment-grade portfolios, spread-change risk usually dominates.