GMO: ‘It’s Too Early to Rush’ for Imperiled Credit

“Right now it’s bad businesses with bad balance sheets,” a portfolio manager warns.

The Federal Reserve building in Washington, D.C. (Andrew Harrer/Bloomberg)

The Federal Reserve building in Washington, D.C.

(Andrew Harrer/Bloomberg)

The coronavirus pandemic brought a surge of bankruptcies and missed interest payments — but attractive opportunities in distressed debt remain scarce, at least according to GMO.

The issuers accounting for much of April’s defaulted debt were struggling well before Covid-19 shut down the economy, the firm argued in a new white paper.

“It is too early to rush into the first defaulted debt opportunities as the risk-reward remains poor,” wrote Jeff Friedman, co-portfolio manager for GMO’s main distressed-credit vehicle.

April’s $36 billion in default volume, for example, had major drivers in Frontier Communications and Intelstat— companies that were headed for a restructuring “regardless of the coronavirus pandemic,” according to GMO.

“The businesses that have already gone bankrupt or are going bankrupt any day now — all these businesses have had major problems for years, frankly,” Friedman said by phone Friday. “We like to buy defaulted debt when we buy a decent business with a bad balance sheet, and right now it’s bad businesses with bad balance sheets.”

That said, GMO doesn’t see much opportunity at the other end of the credit market, either. The U.S. Federal Reserve’s move to include high-quality high-yield debt in its bond-buying program has led to a rally in BB-rated bonds, diminishing the opportunities in that sector, according to Friedman.

“While we believe that credit remains very attractive overall, we believe that BBs have rallied so much that it is not wise for investors to simply own the high quality, highest beta part of high yield at this time,” he wrote in the paper.

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Where credit investors can find opportunity, according to GMO, is the area between Fed-approved bonds and defaulted debt.

“We have found that this area of the credit market has created a unique mispricing where we are able to acquire the debt of quality businesses facing short-term business complications at low dollar prices with equity-like total return potential, but without the long-term secular challenges faced by the current crop of defaulted debt,” Friedman wrote.

For instance, Friedman told II that GMO has invested in the debt of a “high-quality media company that has a very large market cap.” These bonds, he said, were purchased at less than 80 cents on the dollar.

“Easily a double-digit total return opportunity,” he said. “They’re going to get hurt really badly in 2020, but they were operating really well and performing really well up until mid-March.”

Other examples include an insurance brokerage business with debt that’s now trading at prices below 90 cents on the dollar, down from 105 cents pre-coronavirus outbreak, and a healthcare company that makes personal protective equipment. The healthcare company’s bonds are down 10 to 15 percent this year, despite its equity rallying.

As the coronavirus crisis continues, Friedman said he expects to see more attractive opportunities in the distressed debt market as more companies are forced to file for bankruptcy.

“Into the first half of 2021 — that’s when newer, more exciting bankruptcies might happen, and that could ultimately be the time when it’s valuable to be buying defaulting debt,” he said. “It’s hard to be certain about the timeline — but it is certainly a lender’s market right now.”