Attention, investors: For those of you kicking yourselves for not seeing the subprime mortgage blowup coming a mile away, here’s a chance to feel smart again. There’s a whole new problem brewing and this time you can get ahead of the headlines.

Welcome to the high-yield markets. Thanks mainly to the boom in leveraged private equity buyouts, an unprecedented amount of low-grade debt is coming to market these days. At the same time, record-low default rates have buoyed investor confidence, so that spreads (the difference in rates between high- and lowquality paper) have been unusually narrow. Because a healthy economy has buoyed businesses, lending standards have become lax and lenders über-confident. More than one private equity firm has been dumbfounded at being offered more money than it has asked for, so eager are banks to lend.

According to a recent presentation made by John Olert of Fitch Ratings, the past three years have seen $477 billion in high-yield debt issues, of which 67% was rated below BB. The amount of single-B and lower debt as a portion of noninvestment-grade debt issues has been steadily increasing since 2002, when such paper constituted less than 55% of the deals done. In the first quarter of this year, another $41 billion of high-yield paper came to market.

These conditions almost guarantee a wave of defaults and restructurings down the road. Indeed, the Fitch presentation concludes, “The slide down the rating scale suggests the next default wave will be more severe than the 2001-2002 downturn.”

There are already some hints that all is not well in the sector. Last week Standard & Poor’s published a report titled “The Covenant-Lite Juggernaut Is Raising CLO Risks — And Standard & Poor’s Is Responding.” The report details the growth in collateralized loan obligations being made with virtually no covenants, provisions that have historically required borrowers to meet certain financial tests dictated by lenders. S&P points out that so-called cov-lite loan volume in the first quarter “exploded to $48 billion — a stupendous figure by any measure — from the $24 billion full-year 2006 total.” It projects that “when the cycle turns (as is inevitable) lenders … will rue the day they gave up on maintenance covenants.”

More alarming to traders was last week’s news that a deal for an energy company, Plains Resources, had to be downsized and repriced when buyers of the company’s lowerquality paper required a higher yield. The market quivered in anticipation of a more far-reaching response.

It never came. According to Jeff Rowbottom of Barclay’s Capital, speaking last week at a forum hosted by the New York Society of Security Analysts, institutions like pension funds have increased their allocations in high-yield investments, causing a large flow of resources into the sector. Investors in high-yield, including hedge funds, hold sizeable cash positions and are eager to take advantage of any dips in price that occur.

Why has the high-yield sector become so important? In part, it is a reflection of the rapid growth of private equity activity. Martin Fridson, author of Leverage World, a weekly that focuses on high-yield strategy, cites a Merrill Lynch report that attributed some 30% of new high-yield money raised in 2006 to leveraged buyouts, the highest level since 1989.

The sector has also grown because of the proliferation of new instruments such as collateralized debt obligations and collateralized loan obligations, which allow banks to pool loans and sell them off to financial institutions broken into various yield and maturity combinations. The advent of these securities has greatly increased the number of players in the debt markets.

What does it all mean to investors? There is a good chance that, down the road, credit will tighten or lenders will become a little tougher, and the ramifications could be dramatic. Just as the subprime mess had an impact on the earnings of financial services companies that had scored big profits from creating the loans, weakening the housing industry, a correction in high-yield markets could slow the pace of private equity activity and cut into Wall Street profitability.

Mr. Fridson is watching regulators for signs that they will step in to require banks to tighten their lending standards. He points out that, in the past month, both the Federal Reserve Board chairman, Ben Bernanke, and the head of the Federal Reserve Bank of New York, Timothy Geithner, have publicly expressed concern at the level of leveraged buyout and bridge loan exposure at the banks.

The impact of pressure on the banks to tighten standards, according to Mr. Fridson — and an early warning sign of a possible meltdown in the sector — will be a “mysterious increase in bankruptcy filings” as companies are no longer able to roll over debt. This prospect is controversial, however, as some would argue that the wholesale securitization of debt has minimized the role of the banks.

Others contend that the very slicing, dicing, and resale of debt itself has put the system in greater jeopardy. This argument suggests that because hedge funds and other lenders hold only tiny pieces of a company’s debt, they have little incentive to work with borrowers to resolve problems. Because the securitization trend is still fairly new, it is not clear what will happen when a company gets into trouble.

At the end of the day, Mr. Fridson expects that a correction will more likely come from borrowers demanding higher risk-premiums. “Normally we’ve seen market-generated responses earlier than anything from the regulators,” he says.

Mr. Fridson does not expect to see world markets shaken by a replay of the 1998 Long Term Capital Management collapse, as the industry has experienced a sizeable upgrading in risk management since then. He notes, however, that securitization has not eliminated default risk; it has simply distributed it more widely.

He also points out other possible complications. For example, a hedge fund could buy secured debt from a company and, at the same time, sell short unsecured debt or equity, betting that a weakened credit position would boost the higher-quality paper at the expense of the unsecured borrowings. The trade might work, but would certainly render that investor unlikely to help work out a troubled loan. Mr. Fridson also notes that, where a bank has some incentive to work through a bad loan in hopes that they will be the lender of choice as the company regains its balance, a hedge fund has no such incentive.

Bottom line? An upheaval in high-yield could slow private equity takeovers, taking some steam out of the stock market and hitting profitability at the investment banks. Cheery thought?

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