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I could see a \r carriage return character from the data you have posted. Was file2.txt transferred from a windows environment to unix?

If yes, please remove the CRLF (carriage return line feed)...

Can you also double check the contents of file2.txt?

Cant make out whats going wrong. It works on my system. Please double check the contents of file1.

-Raja

Can you include set -x at the beginning of the script and execute? Or execute using sh -x scriptname.sh

while read LINE
do
sed 's/XXXX/'$LINE'/' file1.txt >>file3.txt
done<file2.txt
cat file3.txt