This article explains the reasons behind the movement in a selection of the largest U.S. cash merger arbitrage spreads from the past week as calculated by Merger Arbitrage Limited. We analyze the attractiveness and profitability of each spread going forward and indicate the trading position or action we have taken or intend to take based upon the analysis given.
This week's strongest performer was Mellanox (MLNX), which finished the week up 1.35%. As is a common theme this week, there was little news to report. Spread movements have been widely influenced by broader market movements caused by increased bullish sentiment with regards the domestic economic situation. MNLX however was one of last weeks biggest losers and the volatility in this stock makes it a prime target to benefit heavily from broader market movements. The offer of $125 per share is from Nvidia (NVDA)
Array Biopharma (ARRY) was the second biggest gainer this week up 1.17%. This is a tender offer, which is scheduled to close July 26. Two filings were made during the week detailing amendments to the tender offer. The spread is currently offering 2.41%. On an annualized basis, this is an impressive return, which suggests the market is becoming more positive of a successful initial offer. We are looking to take a small speculative position in this deal during the coming week.
El Paso Electric
El Paso Electric (EE) makes a rare entry into the biggest movers category this week as the stock moves up 1.16%. The simple spread is still offering 4.91%. However, expected closing is not until the middle of next year. With early closing, the annualized spread is an investment possibility. In the meantime, Adrian Rodriguez was Named Interim CEO of El Paso Electric. There was no mention of the pending takeover from Infrastructure Investments Fund made during this announcement.
Pacific Biosciences of California
Pacific Biosciences of California (NASDAQ:PACB) was also amongst the winners this week. The stock closed up 0.99% at $6.11. This continues the recovery from the recent low $5.80's. This is due to the clarification of the deal with Illumina (ILMN) being elevated to a phase 2 investigation by the CMA. We have added to our position during the week and following our earlier analysis of awaiting further deal clarification, we continue our active arbitrage strategy. Following any further rise in the coming week(s) we will be looking to exit part of this position.
WABCO Holding (WBC) was the only decliner of significance this week. There was no news and we mention the decline solely for the sake of completeness. The stock finished down by 0.40%. This deal currently offers 3.35% and we continue to hold our position.
Merger Arbitrage & Market Data
The broader market had another great week despite the mid-week holiday. New highs were obtained yet again against a backdrop of positive news from the domestic US economy. Positive sentiment regarding the ongoing U.S.-China trade talks was another positive factor. Despite the increase and firmness of the labor market, interest rate fears have yet to creep back into investors’ minds. A shift in central bank policy due to inflationary concerns could deal an unexpected blow to market progress. The S&P 500 ETF (NYSEARCA:SPY) finished up 1.80%.
The IQ ARB Merger Arbitrage ETF (NYSEARCA:MNA) was almost unchanged. By Friday, the MNA ETF was marginally up 0.06%. (You can read our analysis of the MNA ETF in the "Strategy" section at the Merger Arbitrage Limited website).
Merger Arbitrage Portfolio Analysis
U.S. based cash-only merger arbitrage positions saw 16 advances and 3 declines this week with 1 non-mover. The top 20 largest cash merger arbitrage spreads as defined by MergerArbitrageLimited.com improved by 0.46% and the standard deviation of returns was 0.50%. This is way below the level experienced during the last few weeks and significantly below the 3-month and long-term averages. The performance of the portfolio was attributed to broad based increases in the majority of the spreads.
The top 20 discount spreads now offer an average of 4.96% despite the gains made during the week. The T20 portfolio has 20 deals and 0 vacant spots filled by cash. The portfolio (available from the Merger Arbitrage Limited website) has once again become reliant on a handful of spreads for the high average return. This is signified by the size of the PACB arbitrage spread to more than 30%.
Merger Arbitrage Strategy
Halfway through the year and a holiday affected week seems like a good opportunity to have a quick recap of the economic situation and how that might effect a merger arbitrage trading strategy. The primary focus remains the U.S. - China trade negotiations. The current situation sees a suspension of tariffs and a resumption of talks as both sides look to save face and walk away with a deal that can be sold as a victory to the crowds back home. An all-out trade war is not beneficial for either country and despite the U.S., taking an initial aggressive stance president Trump is well aware of the negative impact a prolonged trade war will have on his chances of reelection.
Signs of slightly slower growth in the economy has helped keep bond yields down. Markets are speculating over a cut before the end of the year. However, the recent strength in the job market indicates that the domestic economy is chugging along as spiritedly as ever. The market is yet to consider this a threat to a change in interest rate policy. Job growth is of course good news in the long run, but its temporarily bad news for the markets if interest rates have to rise first. Political tensions with Iran could also be set to be the next flashpoint. The recent attacks in the Gulf has sent the price of oil higher and the nuclear agreement seems as distant as ever.
So where does that leave merger arbitrage?
Semiconductors still strike fear into the arbs following Chinas approach to NXP Semiconductors (NXPI) but we still believe in Mellanox. Given the political stakes, and a reelection campaign, a resolution with China is the most probable outcome. Cypress (CY) would also stand to benefit should this be the case.
An increase in interest rates would be negative across the board for merger arbitrage. Longer dated deals will be most affected in the same way longer-term bonds are more sensitive to interest rate movements. However, as newer deals are announced during the change in interest rate sentiment the effect on profitability becomes somewhat muted. Later in the year, some investors may prefer to rotate into shorter dated deals (ie less sensitive to I/R movements) or deals that may be expected to close ahead of schedule. We discuss deal-closing schedules in a separate article.
We have marginally decreased our long exposure from previous weeks. Difficulties remain with individual spreads, but in light of the above, we maintain our positive outlook for the profitability of merger arbitrage.
Merger arbitrage trading is not without risks. This strategy, although accessible to individuals as well as professionals, should be thoroughly understood BEFORE investment capital is put at risk. To assist the reader, "evergreen" content such as "how-to" & introductory guides, a reading list and much more including a list of the largest cash merger arbitrage spreads currently available can be found at the Merger Arbitrage Limited website associated with the author of this article.
Disclosure: I am/we are long MLNX, PACB, WBC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.