Wall Street's last gravy train may be running out of steam

Bankers fear good times for bad debt might come to an end in 2013.

JPMorgan was the top underwriter of risky debt in 2012

FORTUNE -- Wall Street's profits have never been so pumped up by junk.
At a time when most of Wall Street's lucrative businesses -- mergers and acquisitions, initial public offerings -- seem stuck in first gear, sales of high-yield debt have taken off. Worldwide, corporations, municipalities and other issuers sold $420 billion in so-called junk bonds in 2012. In the U.S., high-yield debt issuance topped $350 billion, capping a record three-year run.
In 2010, sales of junk bonds, dubbed so because they are generally considered riskier than higher-rated debt, hit $290 billion. Before that, high-yield bond issuance had topped out at about $150 billion in the best years. Over the past three years, though, sales have averaged roughly double that.
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It's not clear how much Wall Street makes off of the high-yield market, but everyone agrees it's a lot. Dealogic estimates that investment banks raked in $7.1 billion in fees arranging sales of new high-yield bonds in 2012. The large banks tend to dominate the business. JPMorgan Chase (JPM) was the largest underwriter of high-yield bonds last year, generating $716 million in revenue from the business, according to Dealogic. Bank of America (BAC) was No.2 with $646 million in fees. Goldman Sachs (GS), normally a Wall Street titan, ranked sixth, but still generated over $500 million in fees from junk bond sales last year.
But that's just new issues. On top of that, the banks make money buying and selling existing bonds for their customers on their trading desks. More junk bonds should boost that business as well. And bond trading revenue does appear to be up at the banks, though it's hard to tell how much of that is from high-yield. Plain-vanilla bond offerings are up as well, but they are not nearly as lucrative for the banks as high-yield deals.
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One of the surprising things about the high-yield market is that despite the boom, recruiters say few banks are hiring in the area. That could speak to the overall state of banks, which in generally have been laying off staffers in order to cut costs. Or to the fact that many think the good times in high-yield could be fleeting.
After all, it does seem like an unlikely time for a worldwide surge in risky debt. Investors are still smarting from the financial crisis. The euro remains on the brink. The U.S. recovery continues to be anemic more than three years after the official recession ended. And growth in China and the emerging markets in general appears to be slowing.
Oddly enough, that's all created the environment for a junk bond boom. In an effort to boost the U.S. economy, the Federal Reserve has kept interest rates on government bonds as low as possible. That's sent investors looking for yield elsewhere. High-yield bond prices have surged. The riskiest debt returned 18% in 2012. That's pushed yields, which move in the opposite direction of prices and are typically around 8%, to a recent average of just over 6%. As a result, companies, some of which paid double digits to borrow in the financial crisis, are rushing to refinance their debt.
And that's what has some bankers worried. Mergers and acquisitions, in particular leveraged buyouts, are usually the driver of the high-yield market. Refinance activity typically makes up about 30% of high yield bond issuance. But with M&A in an prolonged slowdown, hurt by economic concerns, and rates hitting new lows, refinance activity has come to make up about 70% of the high-yield bond market. Some wonder how long that can continue.
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There is just over $1 trillion in high-yield debt outstanding. This year alone about $250 billion, or nearly a quarter of the total, was refinanced. Refinance activity has been high for the past three years. And bankers say some companies are refinancing long before they have to in order to take advantage of the low rates. The result could be that many deals that would have happened in 2013 or 2014 have already been done, causing a lull.
Junk bond bulls counter that the average rate on outstanding high-yield bonds is about 7.5%, meaning a number of issuers could still lower their payments by refinancing. But that's only if rates stay where they are. After a number of years of good returns, long-time high-yield bond market guru Martin Fridson recently said he thinks junk bonds will disappoint for the next few years. Fridson expects the spread between U.S. Treasury rates and high-yield bonds should increase by about 1.5 percentage points. That means if Treasuires stay where they are, the rate incentive to refinance would disappear, taking Wall Street's recent outsized profits from the high-yield business along with it.