Financial markets rebounded to end the second quarter on a positive note, although bond spreads were historically tight and investors continued to take on risk – often without proper compensation.
Government bonds, negatively impacted from a steepening yield curve, were negative over the quarter, but within investment grade corporate bond markets, the volatility was short-lived – and appetite for yield in high quality credit remained resilient, as investors continued to demand less compensation for added default risk, Canso explains.
Let’s break down some of the highlights from the experts at Canso Investment Counsel Ltd. in their July 2025 Canso Corporate Bond Newsletter.
Tightening corporate bond spreads
Investment grade corporate bond spreads tightened relatively quickly in the second quarter. Despite beginning the year at 114 bps in Canada, “spreads have steadily marched back and are now inside of where they began the year,” Canso says.
It was a similar story in the U.S. market, where spreads for investment grade corporate bonds moved from 83 bps to a wide of 122 bps on April 9th, and then tightened all the way back to 82 bps.
Risk premiums for investment grade bonds in the U.S. “are now the tightest they have been since 2005,” Canso notes.
In fact, the difference is that in 2005 the index had about 10% less in BBB rated bonds than it does today (35% vs 45%) – and as the quarter wrapped, the spread of the BBB component of the Index stood at 110 bps, or 76 bps inside of its historic average.
According to Canso, that makes BBB rated bonds in the U.S. expensive relative to higher quality A rated bonds.
“Historically, you should expect to receive around 64 bps in additional credit spread for BBB over A rated,” Canso writes. “The difference is now just 35 bps as investors demand less and less compensation for the added default risk.
In Canada, BBB bonds also continue to outperform, particularly in the long-end of the credit curve.
“Valuations are now more expensive than they were (in January),” Canso says.
High-yield market
In the high-yield market, credit spreads also peaked in early April and have recovered “nearly all of the widening,” Canso says, noting they are now priced at 321 bps.
“Perhaps we shouldn’t be surprised at this point, but the appetite for yield in the most speculative end of credit markets continues to prevail. High yield bonds are priced for perfection, and we continue to question whether the trade is too asymmetric at these levels,” Canso writes
“On one hand, investors hope to collect a reasonable running yield; on the other, the possibility of price volatility and capital loss through defaults or liability management transactions looms large.”
Limited upside and unlimited risk
To Canso, arguments around whether a higher level of BB rated issues in the index actually make current spread levels reasonable doesn’t hold up.
“Within BB, credit spreads are around the historic lows and at over half the index, this has a bias on the overall. However, if we look at the credit spread of lower quality B rated issues, it is also expensive,” they write.
“At Canso we are focused on bottom-up security selection and pricing individual credit risk. We are finding very few opportunities within high yield, at any rating.”
It’s a concern that also has the experts at Canso watching the increase in Distressed Exchanges, or Liability Management Exercises (LMEs). While these transactions were previously used by Private Equity sponsored companies on the verge of bankruptcy “to inflict pain on rival private creditors, in hopes of staying off a payment default, they have now spilled over into high rated, cash flow positive, public equities,” Canso writes.
“We continue to assert that it is as important now as ever to do proper due diligence and understand what you are buying. At current valuations for fixed income investors, the upside is limited,” Canso says.
“Running yield or modest additional spread compressions is a best-case scenario. The downside, on the other hand, is significant. In this market environment, we will continue to favour quality and liquidity until paid for the risks.
For a deeper dive into the corporate bond market, read the full analysis in the July 2025 Canso Corporate Bond Newsletter.
To learn more about the overall state of the market, check out the July 2025 Canso Market Observer.
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