Got junk

.

  By Guest Blogger Doug Rowat

.

A few years ago, a Government of Canada 5-year bond was providing a yield above 4.1%. Now it’s below 2.75% and appears set to fall even further as the Bank of Canada wrestles with our weakening economy. US Treasury yields have also sharply declined as the Fed is facing a similar battle trying to bolster a struggling US economy.

As investment-grade bond yields decline, it was only a matter of time before our clients started asking about the high-yield (junk) bond market, seeking to juice up their portfolio yields and maintain income.

Lots of things make financial advisors nervous, but near the top of that list is retail investors asking about junk bonds.

Investing is primarily a game of finding sufficient reward for the risk taken. Back in September, I spoke about how online sports-gambling sites sucker investors with parlay bets. Bettors become dazzled by the big payouts offered by these long-shot wagers but fail to recognize that, despite their ostensible attractiveness, the payouts are usually still insufficient for the long odds the bettor faces (in other words, for the risk being taken).

The high-yield bond market is a bit like a parlay bet: the yields may appear sexy at first glance, but closer inspection may reveal that they’re inadequate for the volatility and credit risk being taken on. Naturally, junk bonds have a higher default probability than investment-grade bonds, so the key question is always: is the additional risk being rewarded through a sufficiently attractive yield?

This is where credit spreads come into play.

One useful indicator is the ICE BofA US High Yield Index Option-Adjusted Spread. The indicator’s spread is calculated by subtracting the yields of US junk bonds from US Treasuries of similar duration. The spread therefore indicates the premium, or excess potential return, junk-bond investors can currently realize over a risk-free investment. The option adjustment aspect is designed to eliminate the effect of embedded options, which can skew bond cash flows, thus making the indicator more accurate, but at its core, the ICE spread is measuring the relative attractiveness of junk bonds. Right now, not a great deal of extra ‘reward’ is being offered:

Meh. The yield advantage for high-yield bonds not particularly compelling.

Source: FRED, Turner Investments

So, a high-yield bond providing a yield greater than, say, 6% might seem attractive on the surface, but it’s less compelling on a relative basis. At the moment, junk bond investors aren’t getting much extra yield for the additional risk that they’re absorbing.

Further, according to Standard & Poor’s, the speculative-grade bond default rate in the US is currently 4.6%, not alarming by historical standards (during Covid the rate rose to almost 7% and during the financial crisis to north of 12%), but still elevated relative to its 2022 lows below 2%.

So, high-yield bonds are currently offering a significantly below-average yield advantage and at the same time a somewhat elevated default risk level. In other words, the attractiveness of the high-yield bond market isn’t table pounding. And weaker economic data in 2026 could make the current yield advantage seem even less significant. A weak economy can spell doom for junk bonds as default rates rise.

Portfolio yield can be improved in a variety of other ways. The right mix of equity market exposure can enhance yield (the S&P/TSX Composite or FTSE 100, for example, have double the yield of the S&P 500) and, unlike bonds, equities will raise payouts (dividends) over time hence steadily improving portfolio cash flow. Another option is preferred shares. Preferred shares can offer attractive yields but often have lower default risk than junk bonds because the underlying issuers are usually stable, blue-chip companies.

Sometimes tight credit spreads can indicate stability for high-yield bonds, as they’re a sign that the economy is on solid footing and therefore defaults unlikely. But sometimes the spreads are so tight that the value just simply isn’t there.

At the moment, in my view, the junk bond market is falling more into the latter category.

Time will tell, but exposure to junk bonds may prove to be just another bad parlay bet where the reward isn’t justified by the risk.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.

Source: https://www.greaterfool.ca/2025/12/06/got-junk/