Credit Curves: what steep and flat curves mean

Corporate bonds are issued in a range of maturities.  The usual benchmarks are 10 and 30 years.  Bonds with different maturities, despite both being from the very same issuer (i.e. the same amount of credit risk) often trade at different spreads.  Remember, more/higher spread indicate a weaker credit (as investors expect to be compensated more for their perceived increased risk [of default]).  As a reminder, spread is what you receive in basis points over a comparable maturity risk-free bond.

A 'normal' curve is one where the longer maturity bond has more spread than a shorter maturity bond.  This is stasis...WalMart is more likely to default over the next 30 years than it is over the next 10 years.  

If you look at a broad diversified basket of corporate bonds over time, their curves have historically been 'normal' (i.e. more spread in the longer maturity [aka 'long end'] than the shorter bonds).

When a company's credit is viewed as weakening, you'll see their credit default swap spread widen (aka weaken) and their credit curve (of their corporate bonds) 'steepen'.  

When a company's credit is drastically weaker, their curves actually flatten dramatically and often invert (shorter maturity bonds have a higher spread than longer maturity bonds).  The reason for this is that investors are no longer thinking about whether a company will survive but rather 'if this thing files for bankruptcy, what's my recovery value?'  Remember, most corporate bonds are senior unsecured bonds....so you are near the front of the line in bankruptcy court.  Historically, the recovery rate for corporate bonds is ~$40.  So if you have 2 bonds....one a 10 year maturity and one a 30 year maturity...and both are trading ~$40, your potential annual return (aka yield) is much higher if this matures at $100 in the next 10 years (than it would be if it matured at $100 over 30 years).  

So, for equity investors, another good measure of health in the credit markets to watch are the credit curves of a broad basket of bonds.  One quick and fairly simplistic measure is to watch the steepness of the Dow Jones CDX index between the 5 year and 10 year maturities.  As you would probably expect, they are inverted and have been for some time.  If they 'normalize', you should view that as a good thing.