May 28, 2021 — Merger arbitrage yields have reset to a “new normal” in the post-Covid environment.
Before March 2020, merger arbitrage yields averaged 5%, representing a 300 basis point risk premium to T-bill yields.
Currently, merger arbitrage yields are approximately 8.0%, and with T-bill yields near 0.0%, represent a risk premium or spread of 800 basis points.
The merger arbitrage risk premium, representing the spread between the average arbitrage yield and the risk-free rate, stands at 800 basis points today or 500 basis points higher than fourteen months ago.
The 800 basis points risk premium currently offered in merger arbitrage seems attractive on a relative basis compared to both investment grade corporate bonds and high yield “junk” bonds.
In early 2020, investment grade corporate bonds traded at a premium to Treasurys of 1.3%. Since then, the credit risk premium has fallen by 20 basis points to 1.1%.
Similarly, junk bond spreads have gone from 360 basis points last February to 335 basis points today, falling 25 basis points. With Treasurys yielding near zero, junk bonds now yield a record low sub-4.0%.
To summarize, merger arbitrage spreads have widened by 500 basis points relative to Treasurys over the past fourteen months, while bond spreads have fallen by 20 to 25 basis points.
Merger arbitrage previously offered yields of 60 basis points below that of junk bonds. Now merger arbitrage yields 460 basis points more.
There are simple theories on why credit spreads have tightened, including a highly accommodative Federal Reserve and a recovering economy.
Where the uncertainty lies is why merger arbitrage spreads have widened. These theories include:
- A more hostile antitrust regulator: Investors expect the Biden administration to take a firmer stand against consolidation, and merger investors are concerned regarding the potential actions of an “anti deal” FTC and DOJ.
- A more rational approach by arbitrageurs: Merger investors got smoked in March 2020 as spreads blew out to levels not seen since 2008. Arbitrageurs may be acting more rationally given the battle scars suffered during the last bear market, which saw elevated volatility and several deal breaks and repricings. I have not heard the phrase “spreads are too tight” uttered in quite a while.
Nonetheless, merger and acquisition activity remains brisk, with 14 U.S. M&A deals announced over the past month, representing an aggregate deal value of $44.0 billion. The U.S. merger market opportunity set includes 76 outstanding deals for a total value of $518.4 billion.
Given the relatively attractive risk premium baked into merger arbitrage spreads, especially compared to corporate bonds, the Accelerate Arbitrage Fund (TSX: ARB) has been opportunistically adding to its merger arbitrage portfolio.
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.