What does the term 'credit spread' refer to in fixed income securities?

The term 'credit spread' specifically refers to the difference in yield between two bonds that have varying credit qualities. This concept is crucial in assessing the risk associated with bonds; higher credit risk typically demands a higher yield to compensate investors for the additional risks they are taking. For instance, if an investment-grade bond has a yield of 3% and a high-yield (junk) bond has a yield of 6%, the credit spread would be 3%.

Understanding credit spreads is essential for investors to make informed decisions about risk vs. return. A widening credit spread may indicate increasing risk perceptions or deteriorating credit conditions, while a narrowing spread often suggests improving credit quality or investor confidence. This contrasts with other options that do not accurately define 'credit spread', such as those focusing on overall interest rate differences among all bonds, trading disparities, or fluctuating bond values over time.