In a bond market that is oversold on the government side and heavily shopped on the corporate side, there’s a chance of a broad correction in prices. The consensus is that corporates will outperform governments in the next six to 12 months, but the risks of playing the consensus are substantial.

Short-term government issues in Canada and the U.S. have been priced to the point that they yield almost nothing. A one-year Canada bond pays 0.44%, which actually beats the U.S. treasury bond, which pays 0.43%.

Go out 30 years and you can get 4.01% per year to maturity on a Canada bond and 4.53% on a U.S. T-bond. Markets are pricing in 2% average annual inflation, so the 2% embedded real return is small change for the risk that buyers are taking on long bonds that will plummet in value when interest rates rise.

Even high-yield bonds are in recovery. The Merrill Lynch master II high-yield index shows junk trading at an average yield to maturity of 14.3%, down from 17% in March. And low-rated investment-grade bonds that generated a 6.18% yield to maturity in March have come down to offer just 4.34%.

The effect of all this shopping for fixed-income returns is that the yield curve, still anchored by historically low short-term yields, is steepening. In the last week of May, yields on 10-year U.S. treasuries rose above 3.4% for the first time since November 2008 over fears that yet more public debt will flood into markets, further depressing prices. On June 1, five-year Canada bonds closed the day at 2.56%, the biggest yield jump in eight months.

“The market has supply jitters,” says Edward Jong, senior vice president for fixed-income with MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund, sponsored by frontierAlt Funds Management Ltd. of Toronto. “There are people tripping over themselves with stories about inflation to come.”

Investors are taking on more corporate bond risk and stock risk on slim hopes that the recession is ending. The signals are mixed. On the one hand, the U.S. National Association of Realtors reports that the number of signed contracts to purchase previously owned homes rose by 6.7% in April. Yet, in Canada, household demand for borrowed funds fell by 2.1% in the first quarter. In Europe, unemployment is at a 10-year high at 9.2%, the highest level since September 1999.

Risk is in and caution is out. Buyers want to get in on the bull rush, even if the bull is walking in quicksand. “Demand is largely coming from the long end of the yield curve,” says Michael McHugh, vice president and portfolio manager with Dynamic Funds Ltd. in Toronto. “There has been strong demand for governments and corporates. And, at this point, there is vulnerability to a pullback in yields.”

Investors are rightly skittish about capital markets, given the huge increases in stock prices since March 9 and in bond prices since the end of October. Yet, prices continue to rise only because returns on short-term cash are less than 1%.

It could be years before short-term yields for savings accounts return to the 3% level, McHugh says: “A year from now, three-month T-bill rates in the U.S. and Canada will be slightly higher. The U.S. Federal Reserve Board and the Bank of Can-ada [will] be slow to raise rates.”

It would be simple to shop for corporate bonds for their yields. For example, a Toronto-Dominion Bank 4.78% issue due Dec. 14, 2016, has recently been priced at $92.14 to yield 6.1% to maturity. That’s representative of the yields on mid-term, senior credits. For more risk, a Sherritt International Corp. 7.75% issue due Oct. 15, 2015, has recently been priced at $87 to yield 10.6% to maturity.

The problem with these yields, which are exceptional spreads over Canadas of similar term, is the overhang of debt that central banks are expected to dump on the market. The U.S. has authorized a US$13-trillion extension of the national debt and has already funded US$4 trillion of it, says Chris Kresic, senior vice president with Mackenzie Financial Corp. in Toronto. And avalanches of debt cascading onto the bond market will tend to depress prices and drive up yields.

Bonds are no longer trading just on the yield curve for government debt and on credit appraisals for corporate debt. Technical factors such as supply and demand are gaining in influence, forcing the market to price debt as commodities traders price soybeans. Moreover, the market is being held up and even managed by the U.S. Treasury, which is flooding it with fresh debt and pumping equity into major players such as American International Group Inc., the insurance and derivatives giant being kept on life support by the U.S. government as part of its “too big to fail” program.

@page_break@“If you pull away government supports, then the markets would be less strong than they are now,” Kresic says. “Fundamentals outweigh technical factors — the supply and demand forces — but the long-term risks are being ignored by bond buyers who hasten to buy long governments that are sure to be gored when inflation returns and pushes up interest rates.”

Bond buyers are also ignoring defaults, which will become more prominent before the end of the recession. And defaults are indeed rising. Defaults on U.S. speculative-grade bonds rose to an annual rate of 9.2% in April from a cyclical low of 1% at the end of 2008, according to Moody’s Analytics, a unit of Moody’s Investors Service Inc. U.S. defaults are expected to rise to 14.5% by October, while European defaults are predicted to soar to 19.2% of speculative-grade bonds outstanding by December. (Note that investment-grade bonds slip into speculative territory on the way to default.)

So, where does the bond market go from here? The torrent of money that is being created by the refunding of the credit system in G-7 countries is likely to ignite inflation one day. For now, corporate bonds have good potential returns for investors who are able to find inventory. But buying yield and ignoring risk in this market is like seeing Wonderland as the real thing.

IE