Do Credit Spreads Predict Recessions? Testing the Market Stress Signal

Credit spreads—the premium investors demand for corporate debt over safe government bonds—are widely cited as recession indicators. When spreads widen, it supposedly signals rising default risk and coming economic trouble. But does this actually work? We test 45 years of credit spread data against every US recession since 1980, measuring lead times, threshold levels, false positives, and predictive accuracy. The results show spreads work differently than the yield curve—and sometimes better.

What Are Credit Spreads and Why Do They Matter?

When a company issues a bond, investors demand a higher yield than they'd get from a risk-free government Treasury bond of the same maturity. This difference is the credit spread—compensation for default risk. If a 10-year Treasury yields 4% and a 10-year Apple corporate bond yields 4.5%, the credit spread is 50 basis points (0.5%).

Credit spreads measure market sentiment about corporate health and economic conditions. Banks, insurers, pension funds, and bond traders all watch spreads closely. Wide spreads mean investors are worried about defaults. Tight spreads mean confidence is high. If spreads spike, it could signal trouble ahead.

The Theory: Why Credit Spreads Should Predict Recessions

The logic is straightforward:

1. Defaults rise in recessions: As GDP falls, revenues drop, profits shrink, and some companies can't service their debt. Bond investors anticipate this and demand higher yields before the recession starts.
2. Credit tightening accelerates downturns: When spreads widen, borrowing becomes expensive. Companies cancel investments, freeze hiring, cut costs. This feedback loop turns financial stress into real economic contraction.
3. Market aggregates information: Credit markets incorporate thousands of analysts, traders, and risk managers assessing corporate health. If they collectively widen spreads, they're signaling trouble ahead.
4. Financial stress precedes economic stress: Financial crises (like 2008) start in credit markets before hitting the real economy. Spread widening gives advance warning.

This sounds compelling. But does it actually work in practice? Let's test it.

The Data: 45 Years of Credit Spreads

We analyze the ICE BofA BBB US Corporate Index Option-Adjusted Spread from 1997-2025, and the broader investment-grade corporate spread from 1980-2025 (compiled from Fed data). These track the yield premium of investment-grade corporate bonds over comparable Treasuries. We compare spread movements to NBER-dated recessions.

Test 1: Do Spreads Widen Before Recessions Start?

The first question: timing. If spreads are useful predictors, they should widen BEFORE recessions officially begin (as dated by NBER). Let's measure the lead time for each recession since 1980.

This is notably SHORTER than the yield curve inversion signal, which averages 6-16 months. Credit spreads are a later-stage warning—they widen when recession is imminent, not a year in advance.

Test 2: What Spread Level Signals Recession?

Is there a threshold? If BBB spreads exceed X basis points, does that reliably signal recession within the next 6-12 months?

Test 3: False Positives—When Spreads Widen Without Recession

Credit spreads widen during all sorts of crises, not just recessions. Let's identify false alarms:

The key insight: moderate spread widening (150-250 bps) happens frequently and doesn't reliably predict recession. But severe widening (>250 bps) is a strong signal. Policy responses matter—Fed rate cuts and liquidity provision have prevented several spread spikes from triggering recessions.

Test 4: Comparing Credit Spreads to Yield Curve Inversion

Which is a better recession predictor: credit spreads or yield curve inversion? Let's compare them directly.

Test 5: Do Different Spread Types Predict Differently?

We've focused on investment-grade (BBB) spreads. What about high-yield bonds, or the TED spread (bank funding stress)?

There are three main types of credit spreads that economists and investors watch:

• BBB Spreads (Investment-Grade): These measure the yield premium on bonds rated BBB—the lowest investment-grade rating. BBB companies are solid but not bulletproof: think retailers, mid-sized manufacturers, regional banks. They're on the edge between "safe" and "risky," so their spreads are sensitive to economic conditions without being as volatile as junk bonds.
• High-Yield Spreads (Junk Bonds): These track bonds rated BB or below—companies with higher leverage, cyclical businesses, or weaker credit profiles. Spreads are much wider (400-600 bps normally vs. 150-200 bps for BBB) and spike dramatically in crises. More sensitive but also noisier.
• TED Spread: This is different—it measures the difference between the 3-month LIBOR (what banks charge each other for short-term loans) and the 3-month Treasury bill rate. It's not about corporate credit risk; it's about bank funding stress. When banks don't trust each other or liquidity is tight, the TED spread blows out. This was the key signal during the 2008 financial crisis when it spiked to 450 bps.

Each spread type captures different risks. BBB spreads are the all-around indicator. High-yield gives you earlier, more volatile signals. TED spread is essential for detecting banking crises specifically.

The 2022-2025 Test Case: Why Didn't Spreads Signal Recession?

The yield curve inverted in July 2022 and stayed inverted for 18 months. Yet as of December 2025, no recession has occurred. What did credit spreads say?

Practical Implications

For Investors

• Monitor BBB spreads as a recession timer: When spreads cross 250 bps, reduce equity exposure or add defensive positions. This gives you 4-6 months to adjust.
• Don't panic at moderate widening: Spreads at 200 bps don't reliably predict recession. Wait for 250+ bps before making major portfolio changes.
• Combine with yield curve: Inverted curve + widening spreads = high-confidence recession signal. Either alone is less reliable.
• Consider high-yield for early warning: If you can tolerate noise, high-yield spreads above 800 bps provide slightly earlier signals.

For Policy Makers

• Spreads reveal credit market stress directly: Unlike GDP or employment (lagging indicators), spreads show real-time stress in corporate funding markets.
• Fed interventions work: Rate cuts and liquidity provision have successfully prevented spread spikes from causing recessions (1998, 2016, 2018). Early action matters.
• Watch sector-specific spreads: Financial sector spreads widening signals banking stress (2008). Energy sector spreads signal commodity exposure (2016). Sector analysis adds nuance.

Limitations and Caveats

The Bottom Line

Credit spreads are a powerful, underappreciated recession indicator. They don't give as much advance warning as the yield curve, but they're more reliable when they signal trouble. A simple rule—BBB spreads above 250 bps = recession likely within 6 months—has 83% accuracy over 45 years.

The key insight: credit spreads measure actual corporate stress, not just expectations. The yield curve tells you what bond traders think about Fed policy and growth. Credit spreads tell you whether companies can actually access capital at reasonable rates. When capital markets shut down (spreads spike), recessions follow quickly.

For the 2022-2025 episode, credit spreads got it right: no severe widening, no recession (so far). The yield curve inverted but spreads stayed contained, correctly indicating corporate resilience despite monetary tightening. This reinforces the value of using both indicators together—spreads confirm what the curve predicts.