AlphaRank Merger Monitor -Looking For Yield in All the Right Places

October 27, 2024 — “Bust a Move” is a classic hip-hop song by Young MC released in 1989. It became one of the defining tracks of the late 1980s hip-hop scene, known for its catchy beat, light-hearted lyrics, and broad appeal.

In the hit song, Young MC details a protagonist’s attempt to navigate awkward situations in the pursuit of romance, including “lookin’ for love in all the wrong places”.

Fast forward 35 years (apologies for making readers feel old), and we find income investors in a similar quagmire — looking for yield in all the wrong places.

In terms of the wrong places for investors to allocate, bonds are one of the most unappealing instruments in the current market environment.

And the reason why bonds are unappealing is that they are overpriced, as yields are far too low. When yields are too low, risks are high, making it more likely that allocators lose money in fixed income.

There are two investing rules of thumb to think about regarding where long-term government bond yields should sit, allowing investors to judge whether Treasury bonds are cheap, fairly valued, or overpriced:

1. Long-term Treasury yields should approximate the nominal GDP growth rate — There is a logical thesis that long-term government bond yields should approximate the rate of nominal GDP growth. Since long-term bonds should, in theory, offer compensation for both real economic growth and inflation, their yields are often seen as a proxy for the expected pace of nominal GDP growth. We observe that U.S. nominal GDP growth is currently around 5.5% to 6.0%, while nominal GDP growth in Canada is approximately 4.5% to 5.0%. Considering the current 10-year Government bond yield in the U.S. and Canada of 4.2% and 3.3%, respectively, this thesis indicates that these government bond yields are 120 to 180 bps too low and, therefore, Treasury bonds are overvalued.
2. Long-term Treasury yields should reflect a term premium of 100 to 200 bps over the benchmark rate — The term premium in government bonds is the extra yield that investors require to hold longer-term bonds instead of a series of shorter-term bonds. It compensates investors for the additional risks associated with longer maturities, primarily interest rate risk and uncertainty about future economic conditions, such as inflation and growth. Historically, the 10-year Treasury note has traded with a 1% to 2% greater yield than the fed funds rate. With the current fed funds rate of approximately 4.8%, the U.S. 10-year Treasury note should be trading with a yield of 5.8% to 6.8%, compared with its current yield of 4.2%. Ditto for Canadian bonds. With the Bank of Canada’s policy rate at 3.75%, the 10-year Canadian government bond should trade with a yield of 4.8% to 5.8%, instead of its current yield of 3.3%.

Given current market dynamics, the yields on Government bonds are too low by 150 to 250 bps, implying heightened downside risk for bond investors.

Corporate bonds are priced based on a spread over government bonds of a similar maturity. This spread reflects the additional risk investors take by holding corporate debt compared to government debt. Corporate bonds carry credit risk, liquidity risk, and potentially other risks, which means investors require additional yield over the Treasury yield to compensate.

Corporate credit spreads are at their lowest since 2005, implying that investors are pricing in much good news in the corporate bond market.

Tight credit spreads present limited wiggle room for investors, and it would not take much of an economic hiccup or volatility spike to send credit spreads to average levels, leading to losses for fixed income investors.

Some allocators may push back on the bear case for fixed income, claiming that a central bank easing cycle is bullish for bonds. This argument is problematic because central banks’ ability to control long-term yields and push them lower is limited to quantitative easing, which has been in reverse since the Fed began quantitative tightening in 2022.

The central bank can directly control short-term interest rates through policy tools such as the federal funds rate, open market operations, and forward guidance. However, long-term interest rates are shaped by broader market forces, supply and demand, economic expectations, and investor behaviour. The Fed controls the short end of the curve and the market controls the long end.

What this means in the context of a rate cutting cycle is a steepening of the yield curve, which is currently flat/slightly inverted, as short term rates fall and long term yields rise, pressuring bond prices.

With long term bonds offering such unappealing prospects, income investors need not be glum. Just like when Young MC rapped “every dark tunnel has a light of hope”, yield-seeking allocators have far more attractive alternatives.

Thankfully, there are several options for income investors outside of bonds. Specifically, three alternative yield options, including merger arbitrage, leveraged loans, and private credit. All three fixed income alternatives are attractive given current yield curve dynamics, offering variable rate yields priced as a spread to short terms interest rates (which is where income investors should be focused).

These three alternative yields offer floating rate exposures, priced as a risk spread to the Secured Overnight Financing Rate (SOFR), which currently sits around 4.8%.

SOFR is a key, risk-free benchmark interest rate that reflects the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repo market. It has replaced the London Interbank Offered Rate (LIBOR) as the primary benchmark for variable rate loans and other financial contracts.

In the context of merger arbitrage, investors can imagine the “arbitrage yield” offered by deal spreads as a risk premium over SOFR.

For example, the table below lists the U.S. public mergers announced in October, yielding within the range of 3.6% to 10.6%. While arbitrage yields below 5% include upside optionality priced in (such as a bump or overbid, for example), the average yield of 6.4%, representing a spread above SOFR of 1.6%, is the range where low risk merger arbitrage investments lie.

Source: Accelerate

The current merger arbitrage environment prices low-risk merger arbitrage investments at a yield of SOFR +1–2%. Ergo, for “investment grade” merger arbitrage, one can expect a yield of approximately 6% to 7%. We would classify these merger arbitrage investments as low risk, in line with investment grade corporate bonds. However, low risk merger arbitrage investments differ in that they represent a variable rate yield exposure (priced as a spread to SOFR) with limited duration risk.

The other two main floating rate exposures, leveraged loans and private credit, move investors up the risk curve.

For example, in the current market environment, leveraged loans are priced around SOFR +2–4% (yields of 7% to 9%), while private credit offers spreads of 400 bps to 600 bps above the base rate, equating to a yield of 9% to 11%. We would classify leveraged loans as a low-medium risk exposure, while private credit would entail a medium level of risk, roughly in line with high yield (non-investment grade) bonds.

Source: Accelerate

Compared to the unattractive menu of both government and corporate bond investments, due to low long-term yields and overly tight credit spreads, investors can find solace in the alternative yields offered by merger arbitrage, leveraged loans, and private credit, depending on risk tolerance.

While the 6% to 7% offered by “investment grade” merger arbitrage may be the sweet spot for low risk investors, enterprising allocators can move up the risk spectrum in arbitrage to pursue higher yields. For example, the average merger arbitrage opportunity yields 13.2%, a substantial premium to junk bonds. However, sub-investment grade merger arbitrage investments reflect risks, including the risk of timeline extension (which pressures yield) along with the risk of a deal break (equivalent to a corporate default in which investors lose money). This risk was on full display this month as a court sided with the FTC in its campaign to block Tapestry’s acquisition of Capri, causing Capri’s shares to plummet and leaving arbitrageurs licking their wounds.

October represented a below average month for M&A activity, with 10 deals announced in the U.S. representing an aggregate value of $21.7 billion, with no transactions announced in Canada. M&A activity was concentrated in tech, industrial, and mining this month, with Rio Tinto’s announced $6.7 billion takeover of Arcadium Lithium the largest, followed by Apollo’s proposed $3.6 billion leveraged buyout of Barnes Group. In North America, 14 deals, representing nearly $40 billion in enterprise value, closed in October, while no mergers were terminated.

If investors have or are considering allocating to merger arbitrage, they are looking for yield in the right place. Historically, the merger arbitrage index has outperformed the global bond index with less volatility and lower risk, particularly over the past five years.

Source: Accelerate

In addition, for certain investors, merger arbitrage can be more tax efficient than traditional fixed income, producing a yield via capital gains instead of interest income.

Nevertheless, for those looking for an attractive alternative yield to traditional fixed income without increasing their risk profile, merger arbitrage may be the key. Just like the hook on “Bust a Move” goes — If you want it, you got it.

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.

* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit Alpharank.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.