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A bond portfolio.

After a big growth spurt, Canada's high-yield bond market is facing some growing pains.

For years, the market for bonds issued by lower-rated companies in Canada was small and specialized, despite attempts by bankers and some investors to open it up to a wider audience. In the past couple of years, that finally changed.

With the search for income investments, and scant yields on higher-rated bonds, Canadian investors began to buy Canadian-dollar-denominated high-yield bonds. New funds opened, and new companies tapped the market. Last year, issuers set a record, selling more than $4-billion of high-yield bonds.

The perfect conditions that fed that expansion are abating. Benchmark interest rates are rising, the spectre of default is present, and there is also a lawsuit hanging over one major issuer.

The biggest risk to any and all bondholders is the rise in rates. Some big banks are saying that this selloff maybe the real thing, rather than one of the short-lived breaks in the bond bull market of recent years. Forecasters at Barclays, for example, see this move higher in interest rates as sustained, entitling a recent report "This Time is Different." Bill Gross of Pacific Investment Management Co. has deemed the bull market in bonds finished.

U.S. high-yield bonds are already feeling it, with the iShares High Yield Bond Index fund down 4 per cent since its early May highs. Some of the big junk bond exchange-traded funds, such as the iShares one, are seeing money flow out as investors pull their cash.

Canadian high yield is faring better. But it's unlikely to hold out long against the pull of the U.S. market.

As Barry Allan, who runs one of the country's big high-yield funds at Marret Asset Management, said in a recent commentary: "These valuations are obviously a function of central bank liquidity and the various quantitative easing programs. It is not a question of will high-yield market yields rise but when."

Adding to the interest rate risk, the threat of default is cropping up in a couple of major issues. It's hardly a widespread phenomenon, but the losses are a reminder that these are by definition riskier companies. SkyLink Aviation Inc. filed for creditor protection in March, two months after selling $110-million of bonds in the Canadian high-yield market.

Data & Audio Visual Enterprises Wireless, the mobile phone company company that operates as Mobilicity, is in deep trouble and likely to face restructuring and serious losses for bondholders if its sale to Telus Corp. is blocked by the government. That is a distinct possibility – as the company is barred under current rules from selling to Telus and will need an exception. In fact, the company has a restructuring plan as a fallback.

Bondholders are feeling optimistic. Bonds issued by the troubled phone provider are now trading at 103 cents on the dollar, according to BMO Nesbitt Burns. They won't be worth nearly that if the Telus transaction fails. Even if the transaction succeeds, investors in another class of even riskier Mobilicity junk bonds are unlikely to be paid out in full.

Mobilicity's situation adds another concern. One bondholder, distressed-debt investor Catalyst Capital Group, has launched an oppression lawsuit pitting it against other high-yield bond fund managers and the company over a contested financing.

There are some reasons for hope, relatively at least.

New issuance in the Canadian dollar market has been tepid compared to last year. The lack of new supply should help to buoy prices.

In May, high-yield bonds generally did well. Most Canadian high-yield bonds resisted the fixed-income selloff in May that started in U.S. government bonds. But sooner or later, when government yields move higher, corporate interest rates will too.

Sure, high-yield bonds have historically done better than other bonds in a rising rate environment. They don't get hit as hard as government bonds, because interest rates rising usually implies a stronger economy, which helps companies to pay their debts. One study by Merrill Lynch showed that over the past two decades, yields on high-yield bonds rose about 65 basis points for every 100 basis point increase in underlying government bond yields.

Then again, as Barclays suggested, this time could well be different. The premium that investors demand to own Canadian high-yield bonds over government bonds, or spread, touched a three-year low in recent months. With spreads already tight between Canadian high-yield bonds and government benchmarks, there is less cushion for high yield to soak up the overall rise in rates through narrower spreads.

Owning junk bonds could turn out to be less painful than owning Treasuries or Government of Canada bonds. But getting hurt less than the other guy is small consolation.

(Boyd Erman is a Globe and Mail Reporter & Streetwise Columnist.)

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