February 1, 2025 – Bond investments have been a scourge in allocator portfolios over the past five years.

An elevated inflation rate, a result of excess government money printing during the Covid pandemic, has caused bond yields to surge and bond prices to tumble. In addition, central banks have reversed their quantitative easing measures, reducing demand for bonds and further pressuring prices.

If that was not bad enough, a new government-induced dynamic, including the abandonment of anti-growth, progressive economic policies in favour of pro-growth initiatives, threatens to inflict further pain upon bond-heavy portfolios.

Various economic theories, including those by Wicksell, Solow, Domar, and Fisher, support the view that interest rates should broadly track economic growth. Simply put, Treasury bond yields should be expected to approximate nominal GDP growth. For example, a 5% nominal GDP growth rate (consisting of 3% real GDP growth and 2% inflation) should translate to a 5% yield on the 10-year Treasury bond.

Regarding the outlook for GDP growth, which should ultimately drive Treasury yields, the new Treasury secretary, Scott Bessent, has laid out a “3-3-3” economic plan. One of the “3s” in Bessent’s economic strategy calls for a 3% real GDP growth rate for the U.S. economy. With U.S. inflation hovering in the 2.0% to 3.0% range, current indicators suggest nominal GDP growth rate of 5.0% to 6.0% under the Trump administration. This economic growth rate implies long-term Treasury yields at or above 5.0%. With the U.S. 10-year Treasury yield currently sitting at 4.5% and seemingly poised to rise, a negative experience for bonds investors appears to be forthcoming (bond prices go down when yields go up).

Alas, all is not lost for fixed income allocators. There is an under-the-radar fixed income alternative, merger arbitrage, that is worthwhile consideration in the place of precariously positioned bonds within a balanced portfolio. Essentially, a merger arbitrage investment can be viewed as buying a short-term bond at 95 cents on the dollar. If the merger closes as expected, one gets 100 cents on the dollar and earns an attractive yield above the return on Treasury bills. If the merger terminates, one typically loses money as one would if a bond defaults. Within the context of a diversified merger arbitrage portfolio, a low volatility, consistently performing return stream can be generated.

That said, while merger arbitrage and bond investing are conceptually similar, their precedent performance differential cannot be more stark. Historically, merger arbitrage (blue line below) has not only dramatically outperformed the bond index (red line below) but has done so with lower risk and mitigated drawdowns.

Source: Accelerate, Bloomberg, HFRI

Despite this performance differential, bond funds have continued to experience large inflows, while merger arbitrage has suffered investor outflows. Theoretically, higher returns with lower risk should receive more investor inflows, however, the powerful marketing behind including bonds in a “balanced” portfolio outweighs any theoretical implications.

Nonetheless, certain allocators appear to be changing their tune. In a recent article, Merger Funds Are Ready to Rally. Why They Look Better Than Bond Funds, leading investment publication Barron’s posits that “a more deal-friendly administration could mean fatter returns for funds that bet on mergers...”

The author continues to build their bullish case for merger arbitrage, “less regulation and a dealmaker as president should improve returns, as the likelihood has increased of more merger deals being approved more quickly and ultimately closing… The improved outlook for merger funds comes at a good time, as the bond market has become increasingly volatile in an uncertain interest-rate environment. Because of their low volatility and returns that aren’t correlated with the stock market, merger funds can be used as a bond fund substitute. Whether the stock or bond markets rise or fall, merger funds’ returns move independently, being based solely on whether proposed deals close.”

Government intervention and its effect on investment performance is another similarity shared between bond funds and merger arbitrage allocations.

Governments ultimately caused pain for bond investors through inflation created by too much money printing and too high deficit spending. Moreover, government intervention can be a thorn in the side of merger arbitrageurs through regulatory interference, hurting the yields available in merger arbitrage. Specifically, under the Biden administration, a highly progressive and anti-business antitrust regulatory regime not only punished deal markers and investors through delays and legal challenges of mergers but also caused diminished merger activity through threats and intimidation.

Many expect the antitrust regulatory regime to be friendlier to M&A practitioners under the Trump administration, which is still in flux. Given the recent change in administration, personnel changes are occurring at the U.S. antitrust regulators, the Federal Trade Commission (FTC) and the Department of Justice (DOJ) (which share antitrust enforcement duties depending on the sector).

The FTC is headed by five Commissioners, nominated by the President and confirmed by the Senate. No more than three Commissioners can be of the same political party, and the President chooses one Commissioner to act as Chair. Commissioners vote on whether to challenge a merger, either through litigation or by requiring conditions (such as divestitures) to maintain competition. During the Biden administration, Lina Khan served as FTC Chair, running what became known as “hipster antitrust” with the theme “the only good merger is a dead merger.” Suffice to say, dealmakers and merger arbitrageurs were no fans of Khan, given her anti-merger stance.

Nevertheless, the FTC is undergoing a reorganization. On January 20th, Andrew Ferguson was officially designated as Chairman of the FTC by President Trump. Lina Khan was demoted to Commissioner, and subsequently left the commission, with her last day at the FTC being January 31st. While President Trump has nominated Mark Meador to fill Khan’s recently vacated seat as Commissioner of the FTC, his seat is subject to Senate confirmation, which could be months away. Until then, the FTC will have two commissioners from each political party, with a majority Republican expected after Meador’s confirmation sometime this year.

Personnel changes are also occurring at the DOJ. Biden’s lead antitrust enforcer at the DOJ, Jonathan Kanter, left the organization in December. President Trump nominated Gail Slater to lead the DOJ’s antitrust division, subject to confirmation. Until she is confirmed, Omeed Assefi, a former Trump Justice Department official, has been tapped to temporarily lead the antitrust division.

It was the market’s expectation that the FTC and DOJ, led by Trump’s nominees, would be far more deal-friendly than the previous administration’s antitrust enforcers. That view, however, is up for debate.

This week, the DOJ sued to block Hewlett Packard Enterprise’s (HPE) proposed $14 billion acquisition of Juniper Networks, a merger that has been cleared by every other major antitrust regulator around the world (including Europe and the United Kingdom). Despite the networking companies having a diverse mix of business segments, with 13 separate business units in the proforma company, the DOJ took issue with one segment, specifically, enterprise wireless networking. In the enterprise wireless networking segment, the combined companies will have a market share in the U.S. of around 20%, well below the key threshold of concern of 30%. Nonetheless, the enterprise wireless networking segment is dominated by Cisco, which has an estimated market share above 50%. The DOJ believes that HPE’s strengthened market position will reduce competition, while the companies and customers believe it will increase competition. The net result is instead of the merger closing last week, it is now delayed, with the litigation expected to play out until the summer (unless a negotiated settlement is reached before then). The deal, while uncertain, still has a decent probability of closing successfully, and there are several ways it can work out (behavioural remedy or divestiture). Nevertheless, given the recent litigation against a deal that was arguably “safe”, the market’s expectation of a friendlier antitrust regime under Trump is up in the air.

The U.S merger market exhibited an average amount of activity in January, with 14 public M&A transactions announced worth an aggregate $62.0 billion. Notable deal announcements include Johnson & Johnson’s agreement to acquire Intra-Cellular Therapies for $14.6 billion, Emerson’s proposed merger with Aspen Technology worth $16.8 billion, and QXO’s announced $11.0 billion hostile takeover bid for Beacon Roofing Supply. Whether it is a sign that the M&A environment has heated up under the Trump administration, QXO’s unsolicited bid was the first significant hostile offer since Choice Hotels International’s proposed (and ultimately failed) unsolicited bid for Wyndham Hotels & Resorts in December 2023. M&A activity in Canada was slow in January, with just two public microcap deals announced.

Currently, there are 80 public U.S. mergers outstanding worth an aggregate of $500 billion, with 12 in Canada worth a total of $22 billion.

While the market waits with bated breath for signs of a more deal-friendly regulatory regime, which theoretically should not only spur more merger activity but provide additional certainty along with higher returns for merger arbitrageurs, merger arbitrage yields remain above 10.0%. Despite the odd setback, such as the DOJ’s challenge of the Juniper/HPE merger, merger arbitrage investing does stand out against bonds. Reasons to favour merger arbitrage funds over bond funds include higher yields, tax efficiency (capital gains instead of interest income), significantly lower duration, reduced correlation with stocks, and lower volatility. In addition, merger arbitrage may be facing a positive inflection point with respect to an improved regulatory regime, which could bring more consistency and certainty to the strategy. However, the proof of a friendlier environment for mergers will be in the pudding, and the thesis will need time to prove itself in the coming months and quarters.

The AlphaRank.com 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.

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