What happens to yield spreads when investor confidence in the economy increases?

When investor confidence in the economy increases, there is a general belief that companies and other borrowers will perform better, leading to lower perceived risks associated with their debt instruments. As a result, investors tend to increase their risk appetite. This heightened risk appetite often leads to a higher demand for riskier assets, such as corporate bonds compared to safer assets like government bonds.

As demand for corporate bonds increases, their yields typically decrease relative to government bonds, which are considered safer. This declining yield on riskier assets, combined with stable or lower yields on safer assets, results in a narrowing of yield spreads. Therefore, yield spreads decrease as the market reflects a more favorable outlook on riskier investments, highlighting that investors are willing to accept lower returns for taking on additional risks due to their increased confidence in the economy.