Serious Money:Alan Greenspan, the former chairman of the Federal Reserve, stunned the world's stock markets on the evening of December 5th, 1996, in his address at a dinner hosted by the American Enterprise Institute in Washington. Buried on page 14 of the 18-page and otherwise staid speech, Greenspan asked: "How do we know when irrational exuberance has unduly escalated asset values?"

Although the question referred to the exorbitant rise in Japanese asset prices during the 1980s and their subsequent collapse and stagnation through the 1990s, following two years of outsized stock market gains his intended audience was clear. The drop in stock prices across the globe was immediate, but had no lasting effect as prices continued to march ever higher for a further three years.

Irrational exuberance has returned to global financial markets, but, unlike the 1990s, today it is investors in the world's credit markets that are in need of a wake-up call.

Investors have charged into risky debt of ever more exotic varieties in a bid to boost returns in a very low nominal yield environment - and the money just keeps on coming.

Consider the high yield market. The amount of money poured into European funds doubled in 2006, while demand for American junk soared to $200 billion (€155 billion). The corporate sector has been only too happy to quench investors' thirst for yield as new issuance in both Europe and the US jumped by almost 50 per cent. Nevertheless, investors' heightened appetite for risk continues to outstrip supply, keeping the incremental yield available on junk close to both cycle and all-time lows. Investors point to the current low default rate, record corporate profits and high levels of cash on balance sheets as reasons to remain optimistic. However, the focus on historical indicators is alarming and the optimism could prove to be seriously misguided this year.

The current default rate is barely 2 per cent in the high-yield market, down from double-digit rates in 2002. However, investors appear to be oblivious to the fact that fundamentals have been deteriorating for some time. Indeed, the corporate sector's interest burden bottomed towards the end of 2004, as did the ratio of downgrades to upgrades at the major rating agencies.

Additionally, supply at the higher end of the risk spectrum has soared in recent years and not surprisingly, almost 30 per cent of issuers rated by Standard & Poor's are on watch for a rating downgrade. All indicators point to a default rate of 3 per cent or higher by the end of 2007.

What about record corporate profits? The US corporate sector has enjoyed four consecutive years of double-digit earnings growth, but the rate of growth should slow materially in the year ahead, which assures an increase in both the downgrade to upgrade ratio and the default rate. Revenue increases and nominal economic growth are inextricably linked and the latter slowed to below 4 per cent in the third quarter and is likely to be no more than 5 per cent in 2007. Consequently, revenue growth will slow and margins will come under increasing pressure.

Historically, corporate profit increases have been pedestrian whenever nominal economic growth has been sustained at 4 to 5 per cent, while continued growth below 4 per cent has been accompanied by an earnings downturn. A sustained economic slowdown should see earnings growth drop to below 5 per cent or even less if the boost provided by share repurchases is excluded.

Will corporate liquidity help? The high level of cash on corporate balance sheets has lulled investors into a false sense of security. The current generation of debt investors appears to be lacking in an understanding of the most basic principles of finance. Management is ultimately rewarded for creating shareholder value, while the interests of bondholders are typically an afterthought.

Only in the early stages of an economic cycle are the interests of both shareholders and bondholders aligned. Management is typically focused on reducing the bloated cost structures and repairing the leveraged balance sheets, which arose from the excesses of the previous cycle. The restructuring measures undertaken result in a sharp improvement in corporate profitability, combined with an increased capacity to service debt as the economy recovers.

However, as the economic expansion ages, it becomes ever more difficult to improve profitability through higher margins and greater asset efficiency. Thus, management typically resorts to shareholder-friendly actions at the expense of bondholders. Balance sheets become increasingly leveraged as management increases the level of debt financing in an attempt to boost profitability. The shareholder-friendly actions typically pursued include increasing share repurchases and dividend payments as well as a higher level of debt-financed mergers and acquisitions. All of these actions are apparent in today's markets. Excess cash is being used to the detriment of bondholders.

Risk is seriously underpriced in today's debt markets, with the incremental yield on junk three percentage points below its historical average. Ample liquidity, combined with low yields on Government debt, means the demand for risky debt may continue for some time, though this will only provide investors with a bigger cliff from which to fall. The inevitable is only a matter of time. An emphasis on quality and shorter maturities will prove essential in the coming market downturn.