Waiting for the bond bubble to pop

May 3, 2013: 5:43 AM ET
credit bubble
Low interest rates have sparked a lending bonanza.
LOS ANGELES (CNNMoney)

The bond bubble keeps getting bigger, and investors are getting nervous.

Junk bond yields have never been this low. And the Federal Reserve's moves have helped make it a great time to be a borrower.

Lenders are not only doling out lower rates but in the case of refinancing, they're also willing to let companies skip out on most covenants that attach strings to how much a company must earn to stay up to date with these loans.

Those loans, known as covenant light loans, are nearing levels last seen during the financial crisis.

Leon Black, the chairman and CEO of private equity firm Apollo Group, said investors have completely forgotten lessons learned from the financial crisis, when many of those loans imploded.

"There is no institutional memory," Black told a panel at the Milken Institute Global Conference this week.

Lenders are willing to do "very unique things" to stay in the bond market, said Soren Reynertson, managing general partner at GLC Advisors, who also spoke at the conference.

Related: Dr. Doom: Buy stocks while you still can

The danger with covenant light loans, Reynertson said, is that lenders typically won't get any warning that a company is in trouble.

Komal Sri-Kumar, president of his eponymous global research firm, worries about this debt too.

Citing the infamous quote of former Citigroup (C) CEO Chuck Prince ahead of the financial crisis, Sri-Kumar warned "The music will stop, and not everyone will have a seat."

But at least one investment banker thinks the absence of default triggers that occur with covenant light loans may actually help a company in the long-term.

"Companies are in better shape to withstand ups and downs of economic cycles without these covenants," Adam Sokoloff, global head of the financial sponsors group at Jefferies, told CNNMoney.

He also doesn't think the lessons from the crisis were completely lost, noting that lenders are not letting companies carry as much debt as they did before the crisis.

"Despite the buoyant markets, to date, PE firms are being more disciplined about not taking every last nickel of debt," Sokoloff said.

Related: Fed will struggle to unwind its giant trade

It's not clear how much longer the credit bubble can keep expanding, but the higher the market moves, warns Sri-Kumar, the sharper the drop-off, because the economy simply can't sustain its anemic growth rate without the unprecedented level of intervention by the Federal Reserve.

"It's pretty clear that the markets are being artificially inflated by Fed stimulus or the steroids they've put into the system," noted Justin Slatky, a senior portfolio manager at high-yield hedge fund Shenkman Capital Management.

The Fed will have to stop the music at some point and start increasing interest rates. But until then, banks, companies, and hedge funds seem more than willing to keep dancing.

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