August 24, 2022 – It may not seem obvious to the modern investor, but asset allocation has been around for thousands of years.
For example, the first known bond issue dates back to 2400 BC in Mesopotamia (present-day Iraq). This fixed income investment was a surety bond inscribed on a stone tablet. The bond promised the reimbursement of principal and the payment of grain, which was the functional currency at that time.
The first Government bond was issued by England in the 1600’s to fund its war against France. The U.S Government has been issuing Treasury bonds for over a century. Treasurys are the bedrock of modern investing, providing the yardstick by which all other investments are compared.
Given their historical reliability and consistency, Government and corporate bonds have been core holdings of capital allocators for decades.
Moreover, the 40-year bond bull market, in which the 10-year Treasury yield steadily declined from approximately 16% in 1981 to just 0.5% in 2020, solidified fixed income as a default allocation in investors’ portfolios.
Source: Board of Governors of the Federal Reserve System
While many speculators once thought that Treasury yields may go negative, adding fuel to the fire of the great 40-year bond bull market, surging inflation quashed this theory.
Now the bloom has come off the rose.
Many investors have soured on bonds as the 10-year Treasury yield has risen from 0.5% to 3.0%.
While a 3.0% Treasury yield is not only low compared to where it traded in the 1990s and 2000s, it is puny in the context of 8.5% inflation. An additional surge in rates presents an acute risk for income investors.
As bond yields rise, bond prices fall. As such, fixed-income portfolios have suffered recently. In fact, the bond index has lost all gains it generated over the past 5 years. In addition, the outlook for rates makes bond investors vulnerable to additional losses.
Bond allocation’s pain can be alternative fixed-income’s gain. Enter arbitrage.
Source: Bloomberg, HFRI
Since 2010, arbitrage (blue line above) significantly outperformed bonds (red line above). In addition, arbitrage has provided more consistent returns, with positive performance each year while the global bond portfolio had 5 down years. Moreover, arbitrage provided this outperformance with 19% lower volatility. Higher returns with more consistency and lower risk – what more could an investor ask for?
But wait, there’s more!
Arbitrage generates yield via capital gains, which may be more tax efficient for investors than bonds’ interest income (consult your tax advisor).
Another benefit is that arbitrage can provide positive returns in a rising rate environment, a scenario on every income investor’s mind.
Over the past decade, there have been five years in which bond yields have risen and the bond index has lost money.
Source: Bloomberg, HFRI
As interest rates rose in 2013, 2015, 2018 and 2021, bonds lost money while arbitrage provided positive performance.
2022 has been a doozy. The 10-year yield has increased 1.1% and bonds have gotten crushed, down more than -12%. Despite the interest rate headwinds, arbitrage has hung in there with flat returns.
Looking in the rearview mirror can provide context and a guidepost in terms of what investors can expect in terms of performance from an asset class. However, what really matters to investors is future expected performance.
The yields offered to arbitrage investors compare favourably to bonds. Specifically, the average U.S. arbitrage offers a yield of more than 12% while high-yield corporate bonds offer 7.6%. The yield on investment grade bonds is 5.0% while Treasurys yield 3.0%.
Source: Accelerate, Bloomberg
Arbitrage does not possess the near-legendary status that bonds have within investors’ portfolios. Many allocators remain wedded to the 60/40 stock/bond portfolio irrespective of recent or forecast performance.
Arbitrage may not have been around since 2400 BC Mesopotamia, however, its attractive historical performance combined with enticing forecast future returns makes it a compelling allocation to augment investors’ fixed income portfolios.
The AlphaRank Merger Monitor below represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized returns of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.
Each individual merger is assigned a risk rating:
- AA – a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
- A – a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
- BBB – a merger arbitrage rated ‘BBB’ is of investment-grade and has a high probability of closing.
- BB – a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
- B – a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
- CCC – a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
- NR – a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.
The AlphaRank merger analytics database is utilized in running the Accelerate Arbitrage Fund (TSX: ARB), which may have positions in some of the securities mentioned.
* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit AccelerateShares.com for more information. Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Accelerate may have positions in securities mentioned. Past performance is not indicative of future results.
