A risky part of the market has swelled beyond financial crisis levels - and it could make the next meltdown a whole lot worse

Reuters / Aly Song

• Moody's Investors Service recently published a report warning against an increasingly untenable situation brewing in the bond market.
• The ratings agency argues both companies and investors are engaging in risk-taking activities that that leave the whole market vulnerable to a shock.

For companies, the allure of cheap financing can trump common sense.

At least that's what seems to be happening in the speculative-grade bond market, where the debt burden for non-financial firms is now above its previous peak seen before the 2008-2009 financial crisis.

This troubling development is the focal point of a new report from Moody's Investors Service, which has the so-called junk bond market firmly in its sights. The firm argues the large amount of outstanding high-yield debt is a ticking time bomb waiting to go off.

Of course, when it comes to markets, it takes two to tango, since corporate debt is only as valuable as the investors willing to buy it. As such, the swelling of the junk bond market has coincided with insatiable demand from blindly confident traders looking to keep squeezing returns out of a susceptible market.

"The ranks of low rated issuers continue to swell due to easy market access in a stable credit environment where investors have been reaching for yield," Mariarosa Verde, a senior credit officer at Moody's, wrote in the report. "At the same time, the opportunity to borrow at low cost for mergers and acquisitions and to return capital to shareholders via dividends or share repurchases has proved irresistible."

"When defaults do eventually spike, credit losses are likely to be elevated," she concluded. "Some very weak issuers are living on borrowed time while benign conditions last."

To be clear, the rating agency's point is not that a credit meltdown is imminent. Rather, it's arguing that when turbulence does eventually rock markets and cause defaults, the effect will be far exaggerated due to outsized risk-taking.

And, according to Moody's, traders don't appear ready to stop piling into junk bonds. The firm notes that as junk issuers reach their limits, investors are actually hedging less.

This type of mispricing has also caught the eye of Goldman Sachs, which pointed out last week that the credit-risk premium for CCC-rated bonds - the riskiest segment of the high-yield universe - has fallen to negative 53 basis points, its lowest since 2007.

That type of pricing disconnect offers little bang for an investor's buck, and is unattractive even at non-recession-like levels, according to Goldman, which recommends traders simply look elsewhere - even if owning junk has proven lucrative in recent months.

Good luck convincing them to change their tune. After all, it's their reckless behavior that's gotten us into this situation in the first place.

"The availability of credit and the overall increase in leverage at the speculative grade level has been facilitated by strong institutional investor demand for senior secured loans," said Verde. "The greater use of senior secured financing means that there is less junior debt cushion in speculative grade debt structures which raises the risk that in the next period of broad stress loan recoveries will be lower than they have been historically."