(FORTUNE Magazine) – Remember the righteous indignation everyone felt just a year ago about Wall Street speculators and hedge fund operators? Well, the anger may have faded, but the crisis last August nearly killed the bull market, and the ensuing backlash has sharply diminished the power--and the capital--of hedge funds and trading desks.

Unfortunately, it turns out that corporate America and the investing public may have needed those highly leveraged, fixed-income hedge funds after all. Because the people who were betting leveraged billions on bonds were, in the course of paying for their gazebos in Southampton, also creating liquidity in the markets, and now a lot of that liquidity is gone. That means sellers and buyers effectively have to pay higher fees to get their trades done and wait longer for their money or securities. "You're trying to push a bigger rat through a smaller snake," explains Steven Zamsky, a bond strategist for Morgan Stanley. Andy Fisher, a former Salomon Brothers bond trader who last year started a highly leveraged hedge fund called Convergence Asset Management, adds, "The purchasing power of leveraged investors has been cut by a factor of four."

The drought has been worsened by a rush of borrowing in advance of the dreaded Y2K "turn," the period from November to January that is assumed to be the Death Valley of cash, when some lenders fear their money will be lost in malfunctioning computers. As a result, corporations and bond issuers are being forced to pay higher spreads, or additional interest-rate margins that are way above the rate for safer government bonds.

To put some numbers on this, the middle of the quality range for corporate bonds in the U.S. is the BBB rating by Standard & Poor's. That's the low end of "investment grade" paper. At the low point in spreads this year, back in April, five- to seven-year BBB bonds were going for a spread of 1.27%, or 127 basis points, over comparable Treasuries. At the beginning of this month that spread had widened all the way to 170 points.

Corporate issuance has been running high--by the end of September, about $415 billion in investment-grade bonds will have been issued in 1999. With those numbers, a half of 1% begins to add up. The rise in spreads on just the high-grade bonds issued in the U.S. so far this year will have cost corporate issuers in excess of $10 billion over the life of the bonds. "What we have seen lately is a flight to liquidity rather than a flight to quality in the credit markets," says Peter Rappoport, head of portfolio research for J.P. Morgan.

To make matters worse, it's possible we're going into a period of even higher rates of default on corporate bonds, according to William Gross, a managing director of Pimco, the huge California bond investment firm. Gross, the ultimate lunch partner for bond issuers, says, "There are storms ahead, and spreads won't narrow anytime soon. Yes, liquidity is down because there is a lack of market making, but the big story is the credit-quality problem that is unfolding behind the scenes." Gross cites, for instance, the default rate on junk bonds, which has risen sharply over the past 12 months.

At the moment, of course, there isn't a formally declared crisis in the U.S. financial markets. A grim Alan Greenspan isn't calling for calm. CNBC isn't on deathwatch. But the widening spreads are close to where they were at the height of the crisis last year. And any number of potential problems--a recession, a Y2K crisis, or a market panic--could make things a lot worse in a hurry.

Before you hit the alarm button, though, keep in mind that big corporate borrowers have already done a sizable chunk of the long-term borrowing they'll need for the time being. Moreover, once we get past Jan. 1, the worst of the Y2K crunch will probably have passed.

So what does all this mean for investors? For stock investors, rising yields could put added pressure on already expensive equities. That's particularly true for highly leveraged companies that face heavy borrowing in the coming years.

For bond investors, the story is a bit different. If you have the courage to ride out some short-term volatility and can focus on the long term--especially if you want to buy bonds and hold them to maturity--yields on high-quality corporates are pretty tempting. Unless, that is, the world comes to an end on Jan. 1.

--John Dizard