November 29, 2021 — Fixed income investors are in a tough spot these days.
Inflation is running hot at 6%. The 10-year US Treasury Bond is yielding just 1.5%. Investment grade corporate bonds yield less than 2.7% and BB junk bonds are sporting a 3.6% yield.
Everywhere you look, fixed income investors are generating negative (inflation-adjusted) real rates of return.
It is challenging to find much appeal in negative expected returns, when considering traditional fixed income opportunities.
These negative-yielding investments are unattractive even before considering the significant duration risk. Interest rates are expected to rise in the future, and as they do, bond prices will drop. So, today’s bond investors will be stuck with negative real yields AND capital losses. Does that sound like an appealing combination?
For the enterprising yield investor, there are alternatives. Specifically, SPACs as yield instruments. Here is how the trade works:
Over the past month, there has been a flood of SPAC IPOs, with $14.4 billion raised across 70 new issues. However, the supply flood has not come with a commensurate increase in demand, so the terms offered to SPAC IPO investors have become very favourable.
Specifically, the average SPAC IPO comes with two key features that allow an investor to generate a 7%+ expected return:
1. Overfunded trust: To attract investors to their IPO, SPAC sponsors are overfunding the blank check’s trust account. This means is that for a $200 million SPAC IPO, the sponsor will contribute $4 million to the trust account, so that it will contain $204 million (or $10.20 per share). A SPAC IPO investor buys shares in the IPO at $10.00 and gets rewarded with a 2% return right out of the gate, as the redeemable NAV is $10.20.
2. High warrant coverage: The other tool to attract SPAC IPO investors is to offer generous warrant coverage for each unit in the IPO. Specifically, the average blank check IPO contains 1/2 of a warrant per unit. The average SPAC warrant trades at $1.00. Therefore, the SPAC IPO investor can expect $0.50 per share of value from the free warrants offered to them in the SPAC IPO (1/2 x $1.00 average warrant price). These warrants provide an additional 5% expected return.
The combination of a $10.20 overfunded trust (2% expected return) and a 1/2 warrant (5% expected return) gives SPAC IPO investors an expected 7% return. This expected return comes with minimal downside risk, as an investor is entitled to NAV at the end of the SPAC’s life. However, occasionally no deal gets done and the warrants are worthless (which has happened less than 1% of the time).
What is the estimated timeline of this 7% expected return? The average SPAC duration is 15 months, however, the average SPAC business combination is announced in seven-and-a-half-months from IPO.
So an investor with a diversified portfolio of SPAC IPOs can expect to earn a 7% return in a 7.5 to 15 month timeframe. In an environment in which junk bonds yield less than 4%, that sounds pretty good, right?
But wait, there’s more!
In addition to the return from the overfunded trust and the warrants, SPAC IPO investors have two more sources of additional expected return.
The first additional source of return is small and boring — the yield from the T-bills held in trust. This yield currently equates to a whopping 0.06% per annum. However, this yield will increase as rates rise, which is why SPACs as an alternative fixed income strategy can do well in a rising rate environment.
The second additional source of return can be huge and exciting — the upside optionality on deal announcement. Out of the 117 announced but not yet closed SPAC business combinations, 25% of these SPAC common shares are trading at a premium to NAV. When SPAC shares are trading at a premium to NAV, investors can exit above the $10.20 + accrued interest NAV, leading to additional returns.
There are four sources of returns for the SPAC IPO investor:
1. Overfunded trust: 2% expected return.
2. Warrants: 5% expected return.
3. Trust T-bill yield: nil expected return but could be material in the future.
4. Upside optionality: Uncertain but can be explosive, as outlined in last month’s SPAC Monitor discussion of Digital World Acquisition’s 330% return.
Given the 7%+ expected return from SPAC IPOs, along with the relatively low risk dynamic offered by these investments, the Accelerate Arbitrage Fund (TSX: ARB) has been allocating to these attractive SPAC IPO yield opportunities, subscribing to 19 new issues over the past month. If you are a yield-seeking investor who prefers positive real returns, why are you not doing the same?
The Accelerate AlphaRank SPAC Monitor details various metrics on the current opportunity set while offering details on every individual SPAC currently outstanding. The Accelerate AlphaRank SPAC Effective Yield tracks the average arbitrage yield offered in the market. The Accelerate AlphaRank SPAC Index tracks the price return of the SPAC universe.