Federal Reserve policy makers raised the federal funds rate to 1.75% with three hikes in the period from June through September and indicated a continuation of the quarter-point increases, as economic growth appears to be strong. Rates can be expected to stay on an upward course through this year and possibly beyond. What does that mean for hedge funds?
Merger arbitrage returns will become more attractive as interest rates go up, said Jonathan Bean, managing director of Mellon HBV Alternative Strategies LLC, a manager of several event-driven strategies based in New York.
Other event-driven managers agree. “We are a beneficiary of a gradually rising interest rate environment,” said James Sheehan, director at Brencourt Advisors LLC, New York.
Bean acknowledges that lower bond prices are an obvious positive factor, but argues that several other mechanisms are also at work. A potentially large one is the interest rate earned by the proceeds of short sales of securities.
High rates on short sale proceeds can contribute as much as 20% to 30% or more of the returns in merger and convertible arbitrage funds, he estimated.
Moreover, a wider spread blunts the force of unexpected market moves. Merger arb managers might earn two and a half to three times the risk-free rate. A transaction is less likely to have a major effect on the portfolio if the fund is earning 12% instead of only 3%. “At higher interest rates, it is easier to withstand mistakes that might occur,” Bean said.
To the extent that higher interest rates drag down stock prices, the effect on M&A can be negative. But it depends on timing. If both equity markets and interest rates rise for a few years, that would make for a friendly merger arb environment.
As alternative investment strategies continue their meteoric ascent in the financial industry, experts expect the number of mergers and acquisitions will increase commensurately. Executives at New York-based Freeman & Co. view the current uptick in M&A activity as another step in the evolution of the hedge fund industry into the investment mainstream.