Security-seeking in-vestors who use bonds for income rather than speculative return are in a time of trouble because yields on Government of Canada bonds are as flat as a Saskatchewan wheat field.

A two-year ride in a federal bond pays 3.91% to maturity, five years pays 3.90%, 10 years pays 4% and 30 years pays a measly 4.08%.

Investors with a taste for a small amount of adventure can pick up a Nova Scotia 4.60% bond due in 2016 and get a little boost to 4.30%. One can also go down the ranks of credit ratings to an AA-rated Royal Bank of Canada 10-year issue that pays 4.60%; a Loblaw Cos. Ltd. 10-year A-rated bond that pays 4.75%; or a BBB-rated Nexen Inc. 10-year issue that pays 5%.

Thereafter, yield-seekers can prospect in the land of junk. A 10-year GMAC (Canada) bond, rated BBB-low by Dominion Bond Rating Service Ltd. and BB by Standard & Poor’s Corp. (both of which have the company on their ill-boding credit watch), pays 7.25%.

For a higher theoretical return, turn to income trusts. Art in Motion Income Fund offers a theoretical yield of more than 24% because it has lost more than half its market value in the past year. Or you can seek out Gienow Windows & Doors Income Fund for its 17.1% theoretical yield, based on a price that has dropped by about 60% in the same time frame.

Yield gains on corporate bonds compared with government bonds are very small, says Robert Marcus, president and chief investment officer of Majorica Asset Management Corp. in Toronto: “Corporate spreads are record tight. The corporate bond market is pricing in a soft landing for the U.S. economy.”

Corporate-bond buyers may be optimists, but the yield-seeking investor is left with a dilemma: how much risk should he or she take for a given boost in yield from bonds or, for that matter, from income funds?

As the accompanying table shows, chances of default rise dramatically as bond quality declines. Risk of default also rises with time. Over a 10-year period, a BBB-rated bond from a Canadian issuer is 2.4 times as likely as an A-rated bond from a Canadian issuer to default. But the yield pickup these days is just 25 basis points.

As a result, this may not be the right time to buy corporate bonds, warns Brad Bondy, director of research at Genus Capital Management Inc. in Vancouver: “There is not enough reward for risk. There is a temptation to go for more yield, but that is the opposite of what you should be doing.”

What’s more, if the U.S. Federal Reserve Board has overdone its two-year cycle of moving short-term rates to the current level of 5.25%, the U.S. economy — and, probably, Canada’s — will suffer “a severe slowdown,” Marcus warns.

That would mean a widening of spreads — in other words, a significant drop in corporate bond prices.

Bondy’s advice is to wait for spreads on corporate bonds to widen, which should occur in 12 to 18 months. If he is right, corporate bonds will provide more reward for the risk. But the question is just how much risk you should take.

This is also a question of diversification: the higher the level of risk, the more diversification you need. If all you want is a Canada bond with a five- or 10-year term, there is no need to diversify. One Canada bond is as good as another for risk and, these days, for yield to maturity. A five-year AA-rated corporate bond is probably fine as well, as the odds of Royal Bank flopping within five years is remote, to say the least.

But, in BB-rated territory and downward, the odds of failure are so great that you have to spread the risk. “Only experts should buy BBs,” says Tom Czitron, managing director for income and structured products at Sceptre Investment Counsel Ltd. in Toronto. “In a small portfolio of BBs, one default and you’re toast.”

That is even more true for income trusts. They can cut distributions or eliminate them entirely, leaving unitholders with no recourse. Not even holders of dubious junk bonds have so little power to get their money.

So, can a yield-hungry investor survive on 4%? Czitron suggests that, for now, government-bond buyers will get their coupons and no more. For the year ended Aug. 31, Canadian bond funds produced an average return of 1%, while high-yield bond funds produced an average return of 1.3% for the same period; there is a pickup in yield for taking on the risk. But for the 10 years ended Aug. 31, Canadian bond funds had a 5.9% average annual compound return, vs the 4.6% average annual compound return of high-yield bond funds in the same period. If high risk does not translate into high return over the mid- to long run, why bother?

@page_break@You would do better to ask the question of what management is worth. The SC universe bond total return index produced a 2.1% gain for the 12 months ended Aug. 31. That’s twice the average of Canadian bond funds in the same period. Both categories include a blend of government and corporate bonds. The index has no fee and it can be bought as an exchange-traded fund on the Toronto Stock Exchange. It has a 30-bps MER, which is a small fraction of the 1.97% average fee for managed bond funds.

The ETF wins the return game because it is cheap, not because it is better than managed bond funds.

In a time of constrained returns, with fees about twice the level of what bond funds have returned, it’s cost control that counts more than loss control when descending the ladder of credit quality. IE