Gordon Gekko isn’t the only jailbird 1980s financier to make a comeback this year. The junk bond market, largely the brainchild of Drexel Burnham’s Michael Milken, is set to have a record year. The difference between the two: Gekko’s financing strategies were sounder. It is now possible to identify the next bubble being blown and eventual money-pit created by irresponsible Fed policy.

Junk bond borrowers have raised $168.5 billion in the year to September 15, according to Dealogic, surpassing the full-year record of $163.6 billion. Since that record was set in 2009, you can see that junk bond issuance is running far ahead of all previous levels, extraordinary in the deepest recession since World War II. What’s more “covenant-lite” bonds, which had been thought an aberration of the 2006-07 bubble, have returned in force, with more than half the bond issuers this year receiving lesser covenants than on any of their previous deals. Investors are encouraged by low default rates, which according to Moody’s were down to an annual rate of 5.1% in August from a peak rate of 14.3% set in November 2009.

That demonstrates that junk bonds are in a bull market; it does not demonstrate them to be in a bubble, nor does it show conclusively that gigantic losses are in prospect. To see the market in a full perspective, it’s necessary to revisit a little history that may be unfamiliar to younger readers.

There has always been a modest market for high-risk corporate bond issues. After all, interest is tax deductible, so it did not require deep understanding of the Modigliani-Miller Theorem to realize that borrowing more debt than most companies might be a good idea. (The M-M Theorem is one of the central fallacies of modern financial theory; it states that a company’s capital costs are invariant with its capital structure, so the rational company, seeing that debt interest is tax deductible, leverages itself up to the eyeballs. It’s a fallacy because bankruptcy imposes large costs, both on the company and especially on its workforce and creditors, which the theory does not take into account.) In the late 1970s, a young Drexel Burnham analyst, Mike Milken, carried out careful studies, and demonstrated that junk bonds provided higher risk-adjusted returns than conventional corporate bonds.

Like many truths in finance, Milken’s new discovery became untrue as soon as it was discovered and widely exploited. An obscure market with medium sized companies making small junk bond issues bought by savvy investors became a huge circus with sharks raising billions of takeover dollars and selling bonds to dozy or venal institutions. The process on both the issuer and the buyer side was completely different, the amounts of money involved were orders of magnitude larger and the differences between the piranhas and the chum in the market became immense. While theoretically the new Milkenized junk bonds might have offered superior returns – they were after all still subsidized by taxpayers through the corporate debt deduction – there was no legitimate reason to believe a priori that they would. Even without chicanery and insider trading (which to be fair were no more than a part of Milken’s junk bond operation) it was likely that investors in the new securities would be painfully disappointed.

When Milken was arrested in 1989 and Drexel collapsed the following year, it seemed that the inevitable denouement was occurring, after which the junk bond market would revert to its peaceful if at the edges unsavory traditions. Milken’s favorite piggy bank, Executive Life, went bust in 1991; Credit Lyonnais, France’s largest bank collapsed into scandal in 1993, and the market seemed destined to sink back into obscurity. The volume of new issues, which had peaked around $30 billion for several years in the late 1980s, accounting for 23% of debt issuance in 1988, fell to $10 billion in 1991 and remained below its 1980s levels until the middle of the decade. However defaults were not as serious as had been expected, peaking at around 8% of outstanding debt in each of 1990 and 1991, while investor returns on junk bonds, which had collapsed in 1990, were over 40% in 1991.

The relative lack of defaults in the junk bond market and the easy money conditions prevailing after 1995 caused a frenzy of junk bond market activity paralleling the tech stock market in the late 1990s, until the Enron collapse in 2001 caused another downturn, albeit not as severe as that of 1989-90. Then market liquidity caused a further boom in 2002-07, which in turn caused defaults to rise to a record level of an annualized 14.3% of outstandings in November 2009. At the current time, around $850 billion of junk bonds are outstanding, retail money flows eagerly into junk bond investment funds and the market has a more or less savory reputation, besmirched rather less than Wall Street in general by the revelations and scandals of 2008-09.

There are two reasons why junk bonds have performed unexpectedly well in the last two decades, failing to undergo a real correction in 20 years. First, the taxpayer subsidy to debt issuance is a major factor. Companies that finance themselves largely with junk bonds have a capital cost advantage against their conventionally financed competitors. That explains the explosion in private equity funds. The idea that corporate management becomes magically motivated by being promised oodles of cash is rubbish. However the tax subsidy allows management and private equity funds to pay themselves bonanza payouts while through judicious statistical flim-flam convincing investors that returns are adequate, with only the nation’s taxpayers really suffering, at least in the short run.

The second reasons for junk bonds’ relative success, or at least non-collapse, is that they have been operating since 1981 in a uniquely favorable interest rate environment, in which there are no severe credit crunches and interest rates decline on a secular basis for almost three decades. This favorable market has been exacerbated since 1995 by the Fed’s persistent easy money policy, expanding money supply faster than GDP year after year and ensuring that there is always a glut of leverage financing looking for deals.

That makes default very unlikely for a company in a stable business whose operations are even moderately competently run. If it is able to borrow at 10% in one year and then two years later runs into difficulties, the chances are that money will be available at 8%, allowing it 25% more borrowing capacity at the same or lower interest costs. That secular decline in interest rates, allied with the Fed-induced upward sloping yield curve (allowing companies to borrow short-term from banks at lower interest rate costs if the market is in a temporary hiccup) has allowed company after company to avoid bankruptcy, even increasing its capital value through aggressive refinancing. Of course from time to time a Blockbuster will get in difficulties and be forced to file for Chapter 11, but even in that case an arrangement has been reached with creditors to continue operating, though technology has made Blockbuster’s business model as obsolete as the buggy-whip business.

This cannot last forever. Arithmetically, interest rates are now close to zero and even Ben Bernanke might jib at paying junk bond issuers to borrow money (or maybe not – who knows; let’s hope we never find out!) Thus at some point in the fairly near future, whether driven by resurgent inflation or by a collapse of confidence in US Treasury bonds, interest rates will start going up. At that point, the bull market in junk bonds will come to a sticky end. Companies which have borrowed at 6% and run into difficulties will find new financing available only at 8%, making their difficulties un-surmountable.

The default rate on junk bonds will rise above 10% and, unlike in 2009-10, stay there. The collapse in junk bonds will be accompanied by a similar but arithmetically larger collapse in the leveraged loan market. Leveraged buyouts will become impossible, and overleveraged companies will be forced to choose between finding additional equity and bankruptcy. Capital values will again collapse, and a “tight money” market will ensue such as we have not seen since the Volcker years of the early 1980s.

That, not temporary slowdowns in current economic activity, will cause a double-dip US recession, and a very nasty second dip it will be. What’s more the Fed, by engineering collapsing bubbles successively in dotcoms, housing and now junk bonds and leveraged loans, will have decapitalized the U.S. economy. Savings have been suppressed for close on two decades, preventing the natural accumulation of capital as baby-boomers drew closer to retirement, while the majority of the country’s magnificent and unmatched capital stock will have been poured down a succession of ratholes. In an era of globalization, the result of such de-capitalization will be a rapid downwards convergence of US living standards towards those of the less provident members of the Third World.

Ben Bernanke may well be remembered in 2100 while all other Fed Chairmen within 50 years either side of him have been forgotten –but to the impoverished mass proletariat of that era, he will be known as the Bernard Madoff of monetary policy.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)