The Undervalued Role of Credit Ratings in a Volatile Market

In an era of economic uncertainty, the role of credit ratings has become both a cornerstone and a cautionary tale for investors. As the high-yield and leveraged loan markets grapple with structural shifts and looming recession risks, the reliability of credit ratings—once seen as a definitive guide to risk—has come under scrutiny. Martin Fridson, a seasoned authority on distressed investing, has sounded the alarm on the growing disconnect between credit ratings and the realities of today's credit markets. His insights, rooted in historical parallels and current data, offer a framework for reassessing how investors should approach credit ratings in a landscape increasingly dominated by private credit.

The Illusion of Safety: Rating Agencies and the Private Credit Boom

The private credit market, now valued at $1.7 trillion and projected to reach $3 trillion by 2029, has emerged as a dominant force in corporate financing. Fridson draws a direct line between this growth and the earlier trajectory of high-yield bonds, which, after a period of innovation, spiraled into the 1980s leveraged buyout (LBO) crisis and the 1990–1991 "Great Debacle." Today, private credit faces similar risks: aggressive leveraging, opaque pricing, and a reliance on ratings that may not reflect true risk.

Consider the data: Fitch reports that 17% of private companies now fail to cover interest expenses by even 1.0x, up from 7% in early 2024. Yet many of these borrowers are still rated BBB or higher by agencies like Egan-Jones. This disconnect raises a critical question: Are rating agencies underestimating risk, or are investors overreliant on ratings that lack transparency? Fridson argues the latter, noting that private credit's lack of liquidity and active markets allows fund managers to manipulate reported ratios and inflate returns. This opacity creates a "fair value illusion," where spreads appear attractive until a downturn forces a reckoning.

Structural Shifts: Private Credit vs. Public Leverage

The rise of private credit has also reshaped the dynamics of public leveraged loans. From 2023 to 2025, private credit has financed more leveraged buyouts than the syndicated loan market, according to PitchBook LCD data. This shift is driven by private credit's ability to offer larger, customized loans with flexible covenants—features that banks, constrained by Basel III regulations, struggle to match. For example, the average private credit loan now exceeds $80 million, dwarfing the smaller, standardized transactions typical of public markets.

This structural displacement has had tangible consequences. Public leveraged loan spreads have tightened to near-historical lows (284 basis points as of Q2 2025), while private credit spreads remain wider, offering higher yields. However, this advantage comes with caveats. Private credit borrowers, on average, have weaker fundamentals: lower interest coverage ratios (2.1x vs. 3.9x for public borrowers) and higher leverage (5.6x vs. 4.6x). These metrics suggest that while private credit has historically outperformed high-yield bonds by ~150 basis points, its risk profile is far from benign.

Rating Reliability: A Historical Caution

Fridson's skepticism of rating agencies is not new. The pre-2008 mortgage crisis, where agencies downgraded trillions in toxic assets too late, serves as a stark reminder of their limitations. Today, the same risks loom in private credit. Agencies often assign conservative ratings to private loans, but these ratings may not account for the sector's illiquidity or the potential for a recession to amplify defaults. For instance, S&P Global Ratings reported 32 downgrades in Q2 2025 alone, the highest since 2023, signaling growing fragility in leveraged credit.

The problem is compounded by the lack of a liquid market for private credit. Unlike public bonds, where prices are continuously tested, private loans are priced by fund managers who may prioritize returns over accuracy. This creates a "black box" effect, where investors are left to trust ratings without the ability to verify them. Fridson warns that this dynamic could lead to a market correction akin to the 1990s, where fair value spreads widened sharply during a downturn.

Investment Implications: Navigating the New Normal

For investors, the takeaway is clear: Credit ratings must be treated as one tool among many, not a definitive answer. In a market where private credit's growth is outpacing regulation and transparency, due diligence is paramount. Here are three strategic considerations:

1. Reassess Rating Weighting: In high-yield and leveraged loan portfolios, reduce reliance on ratings and prioritize fundamental analysis. Look beyond BBB ratings to evaluate cash flow sustainability, debt structure, and sector-specific risks.

2. Diversify Exposure: Given the concentration risks in private credit, diversify across public and private markets. Public leveraged loans, while less flexible, offer greater liquidity and transparency, which can act as a buffer during volatility.

3. Monitor Macroeconomic Signals: The forward SOFR curve, currently projecting elevated rates, suggests a "higher-for-longer" environment. Investors should model scenarios where spreads widen by 200 basis points (as projected by Q2 2025) and stress-test portfolios accordingly.

Conclusion: A Call for Prudence

The undervalued role of credit ratings in today's markets lies not in blind trust but in critical reassessment. As private credit reshapes the credit landscape, investors must recognize that ratings are not infallible and that structural shifts demand a more nuanced approach. Fridson's insights serve as a timely reminder: Markets that grow too fast, too far often correct with force. In a world of volatility, the most resilient strategies are those that question assumptions and prioritize adaptability.

For now, the data suggests that the private credit boom is far from over—but the next chapter may be written in red ink. Investors who act with caution today may find themselves better positioned to navigate the storms ahead.