Do bond credit rating services adequately reflect LBO bond risk?

Question

Many private equity deals have been made with highly leveraged capital structures dependent upon large amounts of debt. Is the nature and risk of such LBO debt adequately reflected in ratings by current bond ratings and rating agencies or is the risk underestimated and the ratings overestimated, making such debt eligible for purchase by bond yield funds whose overall risk has thereby increased?

Answer 1

First, I might say that I doubt seriously that you will find any LBO rated about junk status. That is BB. Most are rated at B or below.

As for the rating agencies. They make mistakes all the time. I remember their AAA rated bonds from Washington Public Power going into default. Investors lost everything. They also recently had GM and Ford way overrated. Still do even though they are now rated as junk.

An individual that buys junk rated bonds is assuming a good deal of specific risk. Most are purchased by mutual funds and hedge funds that buy a lot of different ones to reduce the specific risk. When the economy goes into the crapper, even their broad portfolios of junk bonds will suffer greatly.

Answer 2

you'd do well to assume the major rating agencies don't do a very good job. they've had a long, long history of being surprised every few years.

GL