(Bloomberg) -- David Daglio, the former chief investment officer of Mellon Investments, is on a $250 million fund-raising drive to power his new bearish investment fund that’s going all-in on credit market stress. 

The veteran reckons an oncoming US recession will spark a fresh wave of corporate downgrades and debt defaults, with risk premiums for investment-grade firms more than doubling. 

His team has identified lucrative wagers against more than 30 companies in the market for credit default swaps, or instruments designed to hedge exposure to credit risks. The targets include the likes of McDonald’s Corp. and Boston Properties Inc. 

In Daglio’s view, the recent banking stress is just the start of a protracted bout of debt turmoil, with the Federal Reserve effectively powerless to loosen policy thanks to still-elevated inflation.

“The lie being told today is, the Federal Reserve can always bail any type of an endogenous event out,” said Daglio, 56, in an interview. “We love the market’s complacency because it’s giving us an opportunity that I think is really once in a lifetime.” 

Money has kept pouring into investment-grade bonds with exchange-traded funds seeing inflows every month since March 2020, according to data compiled by Bloomberg Intelligence. While bankruptcies are climbing at the fastest pace since 2009, investors remain largely sanguine with credit spreads sitting below their historic average.

Daglio started his Boston-based investment firm dubbed BC-GUMPS in late 2021 after leaving Mellon in the prior year. Since then, he has recruited former colleagues including Corey Griffin and Dale Dutile. 

The team is eyeing credit opportunities because that’s where they see the biggest mispricing and the lowest cost of carrying out bearish wagers. The fund, the first launched by BC-GUMPS, intends to use all its money shorting credit and targets an investment period of one to three years, according to a recent presentation to clients. 

From bonds to stocks, almost all major assets are having an unexpectedly solid year after 2022’s bruising selloff. The S&P 500 has advanced 11%, while a Bloomberg index tracking high-grade corporate debt is up almost 3%. Market speculation that the Fed is set to cut interest rates as early as this year is helping to buttress cross-asset gains while juicing Treasuries and easing volatility.

With inflation staying high, the Fed has stressed the need to maintain restrictive monetary policy. Daglio argues that policymakers ought to stay on course, or they risk losing credibility.  

While the 2020 pandemic dealt a blow to the economy, the BC-GUMPS team treats it as a blip in a prolonged expansion that began after the 2008 crisis.

“The longer the business cycle, the deeper the recession,” said Daglio, who was ranked as Institutional Investor’s best mid-cap core equity fund manager for two years in a row in 2012. 

“The amount of excesses that have been had in this business cycle are unprecedented,” he added, referring to areas such as private equity and commercial real estate. “We have an enormous price discovery that’s going to happen in the credit market.”

Credit Spotlight

Partnering with Valens Research, Daglio and his team have developed a model called “credit image” to uncover companies that have more funding or cash flow issues than implied in their investment-grade securities. 

Earlier this year, the model spotted Boston Properties bonds as being mispriced given a likely decline in cash flows facing the real estate developer. Back then, its debt yielded only 170 basis points over Treasuries. Shortly after Daglio tweeted about the dislocation, the credit spread peaked near 400 points, a level that the team considered less valuable as a short target.

Another opportunity involves McDonald’s, with the market designating the restaurant chain a stellar credit. To Daglio, that’s too sanguine a view as the company faces a pile of maturing debt, a saturating franchise market and a potential drop in consumer demand should the economy sour. 

“It trades as one of the safest credits in the market. We believe it is not,” Daglio said. 

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