June 29, 2021 – In the context of rock-bottom corporate bond yields, merger arbitrage continues to stand out as an attractive strategy for investors seeking to generate yield.
Investment-grade BBB corporate bonds yield just 2.3% and non-investment-grade CCC and lower junk bonds yield 6.7%.
As discussed in last month’s Merger Monitor, pre-Covid, merger arbitrage yields generally sat below that of junk bonds. Based on this comparison, one would expect merger arbitrage to yield roughly 5% to 6%, based on current junk bond yields.
The average merger currently yields 9.1%, highlighting the attractiveness of the opportunity set. Merger arbitrage is now expected to generate returns nearly 250 basis points greater than junk bonds. We haven’t heard the phrase, “spreads are too tight”, uttered in more than fourteen months.
Not only are yields attractive, but the investment opportunity set is expanding. Over the past month, 19 deals were announced representing an aggregate value of $38.1 billion, while 10 deals closed.
The current U.S. merger universe includes 87 transactions for a total value of $520 billion, up from 76 deals outstanding one month ago. If the supply of merger investment opportunities rises without a commensurate rise in capital allocated to arbitrage, expected returns go up.
Given the attractiveness of merger arbitrage within the context of a diversified portfolio, more and more investors have been allocating to the strategy. Merger arbitrage AUM has increased nearly four-fold over the past decade.
Source: BarclayHedge
Despite it being one of the most consistent-performing investment strategies, most investors still lack an allocation to arbitrage. Nonetheless, flows tend to follow returns, and given the potential of the current arbitrage opportunity set, we expect merger arbitrage to outperform bond returns.
One direct consequence of the plunge in junk bond yields is the return of the leveraged buyout.
During the depths of the coronavirus bear market from March to May 2020, private equity was nowhere to be found. We saw zero public U.S. leveraged buyouts over this period.
Now that equity indices are back to all-time highs and the credit window is wide open, private equity activity has surged. Currently, there are 17 live leveraged buyouts, representing 20% of the total deals outstanding.
This urge-to-splurge from the private equity industry is unsurprising, given the private capital industry has accumulated nearly $2.5 trillion of “dry powder”, or money committed to funds by investors but not yet deployed. If these private equity firms want to generate fees, that capital needs to be deployed relatively quickly. With financing rates so low and the clock-ticking on capital deployment, prices paid for acquisitions become much less of a concern.
The below AlphaRank Merger Monitor represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized return 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.
