(FORTUNE Magazine) – As euphemisms go, it's a gem: Instead of "junk bonds," call them "high-yield" bonds. Nobody likes junk, but who could say no to a heftier yield? It's a perfect fix, right? Unfortunately, junk by any other name still smells as foul--and with the market to buy and sell these bonds having recently evaporated, particularly in the telecom sector, many are catching the stink. Scary as it sounds, no small number of banks and insurers that own them could get stuck holding worthless pieces of paper--and the impact is likely to go well beyond big-time institutional investors. Junk bonds have a funny way of permeating the market, and when they go bad, everybody hurts. So if you own mutual funds, shares of big financial companies, or even shares of telecom stocks, you could feel the pain as well.

The first warning sign of just how serious the problem is came in early October, when rumors spread that Morgan Stanley Dean Witter had junk-bond losses of $1 billion on its books. Morgan Stanley denied those rumors and issued a statement declaring that its junk losses were only $45 million. Still, the news put junk back in the spotlight, especially the bonds of the young, fast-growing telecom companies.

Technically, a bond is considered junk when it falls below the investment-grade rating given to federal-government debt and that of established companies. Moody's labels a bond junk (or "speculative grade," another euphemism) if it's rated Ba1 or lower. At Standard & Poor's, anything below BB gets the label. Those lower ratings mean higher yields--often double that of high-quality corporate bonds, or more--but they also mean a higher risk of default. The market gets jittery when junk bonds start defaulting, and that's been happening lately. Last year Moody's saw 99 junk-bond defaults among U.S. companies like Premier Cruises and Planet Hollywood. That's the most since 1991--and Moody's predicts this year will be even worse.

Of course, we've seen this happen before. Junk bonds became popular back in the 1980s as a quick way to finance mergers and buyouts, and the market for them typically operates on a steep cycle of booms and busts. Two years ago the market was flush with new issues, especially from telecom companies. That's why telecoms now account for the biggest chunk of junk--20% of all outstanding issues, compared with a mere 1% less than a decade ago. When tech stocks were soaring, even the lowest-quality, cash-starved telecoms could raise cash via bonds, including companies like GST Teleommunications, a local phone carrier that has filed for bankruptcy protection.

But after a boom like that comes the inevitable hangover. All those recent defaults mean the junk market has dried up, and a lot of the telecom companies are suddenly low on cash. In the good old days (like 1999) they could have tapped the stock market by selling off pieces of themselves. But the market is closed to all but the highest-quality deals right now. So the bonds are starting to behave, in the diplomatic language of Tom Marshella, co-head of leveraged finance at Moody's, "as you would expect low-rated debt to behave." If they're not defaulting, they're trading for pennies on the dollar, which suggests that a default looms. The bonds of local phone carrier ICG and European telecom provider RSL Communications recently traded at just 20 cents on the dollar. Anything below 70 cents is usually cause for concern.

The pressure can be seen most clearly in high-yield bond funds. According to Morningstar, through mid-October junk-bond funds were down around 5% for the year and nearly 2.5% since the end of September. The bigger concern, however, is how that will hit bond underwriters like Morgan Stanley and Goldman Sachs, and commercial banks like Chase Manhattan. "I think this could be the greatest calamity for the banks since the real estate losses of the early 1990s," says short-seller Jim Chanos of Kynikos Associates, a New York hedge fund. Some of those banks were able to pawn off their risky junk debt to insurance companies, mutual funds, and other institutional bond buyers, but that just means the problem is going to appear on someone else's balance sheet.

The wild card in all this is the impact a junk-bond meltdown could have on big providers like Cisco, Nortel, and Lucent. Many of their fastest-growing customers have been relying on the junk-bond market for cash. Without that cash, they're likely to cut back on purchases.

As I said, they don't call these bonds "junk" for nothing.

HERB GREENBERG is a senior columnist at TheStreet.com. E-mail him at herb@thestreet.com.