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U.S. corporate bondholders dabbling with bad old habits

Bondholders are letting some bad habits creep back in. So far this year, they have snapped up some $367-billion of U.S. corporate bonds, according to Dealogic – a 10-per-cent increase on the same period last year. That's good for Corporate America. But it exposes investors to risks that could come back to bite them – again.

First is what happens when interest rates start rising. The Federal Reserve intends to keep them low until at least 2014. But prices can still move sharply – witness the recent fall in the value of both U.S. Treasuries and German government bonds. Eventually, the knock-on effect on corporate bonds will leave pension and insurance funds and the like stuck with paper paying below-market returns.

But bondholders are also snapping up more dross. Witness how much less compensation they're after for riskier debt. The average difference between better-rated junk bonds and paper teetering on the edge of default has narrowed by a fifth, or 1.72 percentage points, since the start of the year, according to Merrill Lynch. The risk premium separating the lowest-rated high-grade debt from solid double-A paper has, by contrast, barely budged.

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In fact, investors have gobbled up bonds sold by some of the riskiest-looking companies this year. Clearwire Communications and Realogy, for example, have both managed to entice bondholders to buy their triple-C-rated offerings. And after a lull in the second half of last year, firms have sold around $11-billion of debt either to buy back stock or fund special dividends for their private equity owners.

None of this is on the same scale as at the height of the last credit bubble. And bondholders may simply be making smart bets on an improving economy. With Europe looking less scary, U.S. banks more sturdy after the stress tests and the nation's unemployment rate falling, that's certainly possible.

But risks remain. Europe could stumble and the Fed has to find a way of weaning the markets off its years-long supply of easy money. Bondholders may hope they will be able to jump ship before the worst hits. But that's hard, and with the Volcker Rule threatening to limit Wall Street's ability to make markets, it may be even more difficult for bondholders to find an exit.

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