The term "credit spread" is the difference between corporate debt (which varies in degrees of default risk) and government debt (considered default risk free). Comparing low grade corporate bond (e.g., BB, B, and CCC credit ratings) spreads to Treasuries is a leading and coincidental economic indicator, which combined with others can provide a fair assessment of the direction of the economy.
Simply put, if the trend shows a widening spread, the better chances of significant economic slowdown. This is logical because if you and numerous other investors sensed an economic slowdown, you would want to seek a higher risk premium for the increased default risk.
For example in 1999 the low grade credit spread was 4.6% then leaped to 8.2% prior to the 2001 recession. This widened credit spread remained as telecom and technology sectors dragged the market down along with corporate governance issues. By the middle of 2004, credit spreads shrank to 2.9% signaling the market was ready for growth.
Just think about it for a moment. If upcoming economic expansion looked favorable in the near term, investors are going to be willing to buy short term and sell long securities. This is also because with expansion comes rising interest rates. This activity will then result in steeper upward sloped yield curve. Investors will ditch their low return, risk free Treasuries and speculate more on the lower grade, higher return corporate debt. As the market pressure mounts the spreads will begin to narrow.
To use this effectively you want to be sure you are comparing apples to apples and oranges to oranges. I suggest comparing the differences between 10 year corporate bond yields to 10 year T-bonds. Also look at 6 month commercial paper relative to the 6 month T-bills. By doing this comparison along other economic data, you will better see where economic trends are drifting. The main idea is that you want to be looking comparable maturities to different asset classes.
In periods of widening credit spreads, I would use extreme caution in owning stocks in the same industry in which you buy below investment grade bonds. Taking a reasonable position in below investment grade bonds to yield a higher return may fit the suitability of many investors. However, if you owned the stock in the same industry and it took a significant pounding in the market, the chances of default increases significantly. Consider that there are numerous combinations of investments that you can have to achieve solid returns for the risk you take. So take the time to ensure that you are properly diversified, especially during periods widening credit spreads.
So to recap in simple layman terms, yield curve spread increases creating positive slope coupled with narrowing low grade corporate debt spreads gives the economy two thumbs up. With flatter yield curve spreads you can expect slower growth rates, and with negative sloped yield curves coupled with widening low grade corporate debt gives you two economic thumbs down.