When it comes to high-yield credit investment, asset manager GMO suggests now is the time to look neither high nor low but somewhere in the middle.
In a white paper released this week, the firm turned a flashlight on what it calls “stressed performers”—good companies that aren’t super-high quality, but neither are they trolling default territory. Instead, these are good companies in the junk category that are merely suffering (like the rest of the world) from a pandemic shock.
“We have found,” writes GMO’s Jeff Friedman, the paper’s author, “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 argues that the Federal Reserve’s announcement April 9 that it would buy junk bonds sent high-yield debt into a shudder of joy, a frisson felt especially among the cream of the “BB” cohort. “Since March lows, ‘BB’ bonds have outperformed ‘B’-rated and ‘CCC’-rated bonds by 3% and 6%, respectively, and through April 2020, ‘BB’ bonds are down only 7% [year-to-date] versus -12% for single ‘B’ and -15% for ‘CCC’-rated bonds,” wrote Friedman.
He writes that there’s a 330 basis point spread between “BB-” and “B”-rated bonds, a yawning gap next to the long-term average of 160 basis points. That means there’s less to hunt in the ‘BB’ bond area today next to more stressed bonds.
But at the same time, Friedman argues it’s too soon to go plowing into distressed debt looking for good companies in default. “The time to pounce on defaulted debt is when there is an abundance of defaults after the default rate has spiked, but not before,” he writes. Friedman points out that the default rate today isn’t that much higher than average when you cut out energy names, and he points to research saying you will pay dear if you go looking for endangered companies too early.
The white paper refers to a study by Edward Altman and Robert Benhenni called “The Anatomy of Distressed Debt Markets.” Friedman says that, according to the paper—“Of more than 500 bonds from 2002 to 2016, the average return for a bond six months prior to bankruptcy was -39%, three months prior to bankruptcy was -25%, and one month prior to bankruptcy was -17%.”
The Radical Middle
Friedman writes instead it’s better to eschew the top and bottom—that it’s better to focus on those companies in the middle that are facing coronavirus-related turmoil but will survive, bloody but unbowed, and that might even offer double-digit returns for the trouble. GMO calls the firms in this margin of grace "stressed performers."
“We have been focused,” Friedman writes, “on a variety of unique dislocations for high-quality businesses facing short-term (but not fatal) challenges from the coronavirus that trade at attractive dollar prices with large public market equity value behind their debt.”
“Our pipeline has never been larger for these stressed performing debt opportunities, and most of these opportunities trade at dollar prices ranging from 70 to 90 cents (down from well over par pre-virus) offering yields of 7% to 15% and total return potential of 25%-plus,” he writes.
He mentions the first-lien debt of companies, including a sports media company and a leisure company, with debt selling at somewhere between 80 to 85 cents on the dollar with either high-single-digit or double-digit yields, and low debt to enterprise values hanging in the 30% area.