When the credit bubble goes 'pop'

Four factors that could affect what the aftermath of the boom looks like.

By Grace Wong, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) -- Cheap debt has never flowed as freely as it does now, but the credit boom won't last forever, experts say.

Hungry for yield and with plenty of money on hand, investors have had a seemingly endless appetite for risky corporate bonds and loans.

Loose lending practices and a growing appetite for risk have fueled a rally in the corporate debt market. But how will it all end?

Default rates have remained near historically low levels, bolstering investors. But industry watchers say with credit quality deteriorating and lending requirements growing ever looser, corporate default rates have nowhere to go but up.

"The numbers have gotten so big and there is such a lack of recognition of risk. Whenever you go this far, things tend to turn out very badly," said David Tice, manager of the Prudent Bear funds.

But how quickly - and how hard - the credit boom unravels, depends on a number of factors. Here's a look at four of them.

A big blow up. Defaults are likely to mount quickly if a notable company unexpectedly collapses, says Sean Egan, managing director of independent ratings firm Egan-Jones.

"It has to be a major company - it could be an auto company that has difficulty with cash flow - in order for it to really be a drag on the market," he said.

Barring a big deal turning sour, Egan thinks the fallout will be more gradual over the next two years. Some leveraged buyouts done over the last 18 months may run into difficulty, which will allow risk premium to re-enter the market, he said.

Recession. A recession would have an adverse impact on the credit markets and could send corporate default rates soaring into the double digits, said James Barth, a senior fellow at the Milken Institute, an independent economic think tank.

While slowing economic growth has caused some worry, few economists expect the economy to nosedive. "Nobody foresees a recession happening anytime soon," Barth said.

Furthermore, the Federal Reserve, which has held short-term interest rates steady at its last seven meetings, has signaled that it's in no rush to either raise or cut rates anytime soon.

Earnings growth. While the economy has slowed, fundamentals still remain strong, said Eric Takaha, director of high-yield research and portfolio manager for Franklin Advisers.

"We don't see a dramatic surge in defaults in the near future - there just aren't enough companies that are close to the edge," he said.

One reason Takaha's upbeat on the near-term outlook is because of the strength of corporate earnings - which have posted double-digit percentage growth for the past four years.

Profit growth for the S&P 500 is expected to slip to 7.2 percent this year from 16.1 percent in 2006, according to earnings tracker Thomson Financial. But many analysts expect the slowdown to be concentrated in the cooling housing sector.

Hedge funds. Hedge funds have become important lenders in the booming market for leveraged loans - those loans given to highly-indebted companies.

Leveraged loans have ballooned amid the buyout frenzy and keep growing. Leveraged loan volume surged to $183 billion in the first quarter, up 55 percent from the same period a year ago, according to Standard & Poor's.

But many of these hedge fund lenders haven't experienced the ups and downs of the credit cycle, and it's unclear how they will react when market conditions take a turn for the worse, industry watchers said.

Known to be nimble movers, hedge funds could send credit markets in a tailspin if they suddenly started backing away from leveraged buyout financing, they said. Top of page