As a result of insurance giant Marsh & McLennan’s financial troubles brought about by New York Attorney General Eliot Spitzer’s allegations of bid rigging, the company’s bonds are trading as if they’ve achieved “junk” status, a state of affairs that was unthinkable only a week ago.

As a result, distressed-debt hedge funds – those that invest in companies that may have trouble meeting their financial obligations – have begun eying Marsh’s bonds.

On October 14, Mr. Spitzer accused the Marsh’s insurance brokerage unit in a lawsuit of rigging bids. Marsh is also accused of collecting huge fees from insurance companies in exchange for business.

Since Mr. Spitzer’s complaint, Marsh & McLennan’s widely held bonds have been clobbered, widening to trading between 230-280 basis points over equivalent Treasuries from 85 basis points above Treasuries.

The company’s most frequently traded bond issue, the 5.375% of 2014, is now yielding nearly 7.70%, placing it firmly within the universe of non investment-grade, or so-called “junk bonds.” Wall Street bond traders told The New York Sun there are no other insurance companies with bonds yielding that high.

The basis of the bond market’s concern was the prospect that Marsh & McLennan would have difficulty paying its bills. Because of the allegations made by Mr. Spitzer, a clause was triggered in Marsh & McLennan’s line-of-credit agreements with its banks that allow the banks to revoke the credit. These credit lines back the $2.1 billion worth of commercial paper – which are 30- and 60-day bond obligations carrying a low interest rate, usually held by money-market mutual funds – that the company used to help meet its cash-management needs.

If the bank lines are revoked, the company may have to pay off the balance of its commercial paper at once, something the company – with a $375 million cash balance as of Wednesday – would be hard-pressed to do.

The Wall Street Journal reported Wednesday that Marsh & McLennan had obtained bank waivers and will have access to its bank lines of credit.

“We are going to have to start paying attention to a company and a sector that I never, ever imagined I would have to look at,” said one New York-based manager of a $200 million portfolio of distressed debt. The manager, who asked not to be identified, said he would need “about a week of hard work to get a handle on a situation that has a political angle to it and no bottom in sight.”

It will be difficult for Marsh & McLennan’s bonds to rally back to their previous prices any time soon since the bond rating they were issued under – A+, one of the highest possible – was cut three levels yesterday to BBB+ by Standard & Poor’s. A three-level cut in a company’s debt rating is rarely done, said an analyst at CreditSights, Rob Haines. Credit-Sights is an independent research boutique catering solely to institutional money managers.

Mr. Haines said the news about Marsh & McLennan’s alleged bid rigging was “pretty bleak,” but he said that the company was not going to experience “a death spiral” given the cash flow created by the company’s diverse business units, which include giant mutual fund manager Putnam Investments and Mercer Consulting. He estimated that in the event the company was forced to raise cash to meet insurance policy or debt obligations, both units could fetch at a minimum $7 billion to $9 billion.

“In the end, Mr. Spitzer wants Marsh & McLennan in business since he is going to run for governor,” said Mr. Haines. “But the company’s business prospects are going to be radically different.”

A ratings agency analyst, Sean Egan of Egan-Jones Ratings Inc., said Marsh & McLennan, after it changed its business practices and paid fines, would go from earning $2.5 billion in operating cash flow this year to $1 billion.

Another bond manager, J.W. Seligman’s Chris Mahony, who oversees a $1.8 billion investment-grade portfolio, said he thought the company would likely survive, but “You’ll need a strong stomach to own this for the next few weeks if you can swing 3 to 4 points a day in price.”

He said the bonds would come under continued selling pressure as investment-grade managers sold the bonds since “they are paid to avoid risk, not take it.”