With the continuing reduction of device dimensions, the impact of the isolation process on device performance becomes increasingly important. A major concern when scaling LOGOS and shallow trench isolation structures (STI) is the build-up of localized stress near the isolation edge, often leading to dislocation formation and altering device characteristics. In this paper, we show for the first time that even when no dislocations are formed, a reduction in isolation pitch can severely degrade the device characteristics, due to the presence of high localized stresses. A stress-induced bandgap narrowing model is proposed and successfully applied to explain the observed behavior.