Phonological difficulties have been identified as a core deficit in developmental dyslexia, yet everyday speech comprehension, which relies on phonological processing, is seemingly unaffected. This raises the question as to how dyslexic readers process spoken words to achieve normal word comprehension. Here we establish a link between neural correlates of lexical and sublexical processing in auditory words and behaviourally measured phonological deficits using magnetoencephalography (MEG). Spatiotemporally resolved cortical responses to phonological and lexico-semantic information were computed with the event-related regression technique (Hauk et al., 2009) and correlated with dyslexic and non-dyslexic subjects’ phonological skills. We found that phonological deficits reduced cortical responses to both phonological and lexico-semantic information (phonological neighbours and word frequency). Individuals with lower phonological skills – independent of dyslexia diagnosis – showed weaker neural responses to phonological neighbourhood information in both hemispheres 200–500 ms after word onset and reduced sensitivity to written and spoken word frequency between 200 and 650 ms. Dyslexic readers showed weaker responses to written word frequency in particular compared to the control group, pointing towards an additional effect of print exposure on auditory word processing. Source space analysis localised phonological and lexico-semantic effect peaks to the left superior temporal gyrus, a key area that has been related to core deficits in dyslexia across a range of neuroimaging studies. The results provide comprehensive evidence that phonological deficits impact both sublexical and lexical stages of spoken word processing and that these deficits cannot be fully compensated through neural re-organization of lexical-distributional information at the single word level. Theoretical and practical implications for typical readers, dyslexic readers, and readers with developmental language disorder are discussed.