Many investors are aware of event-driven equity strategies, wherein the stock of the acquired company is held long, while the stock of the acquiring firm is sold short, generating arbitrage profits when the deal closes. But many of the same investors may not be aware that event-driven strategies can also be applied to credit instruments, which is the subject of a recent paper by Franklin Square titled Event-Driven Credit Strategies: Opportunities for Outperformance.
The objective of event-driven credit strategy is to generate “equity-like returns” with a risk profile more similar to fixed-income. Event-driven equity strategies invest in the stock of companies after the announcement or in anticipation of a “corporate event” – such as a merger or acquisition, a bankruptcy or corporate restructuring, or a shareholder proxy fight.
Event-driven credit strategies work under the same premise, but they add two additional “events” to their list: credit-rating changes and “special situations.”
“Investment grade” is the crucial threshold in credit ratings. Standard & Poor’s (S&P) and Moody’s each have different rating scales, but when a company is upgraded to BBB- by S&P or Baa3 by Moody’s, they officially crossover from “junk” to “investment grade” status – and that makes a big difference in the price investors are willing to pay for a company’s bonds. In the U.S., the difference has averaged 180 basis points over the past three years; or 202 basis points globally.
By conducting extensive fundamental research, event-driven credit strategies try to anticipate corporate-credit upgrades from “junk” to “investment grade” – or the reverse. A company that’s upgraded to investment-grade credit quality is called a “rising star;” while a company that’s downgraded from investment-grade to junk is called a “fallen angel.” Event-driven credit strategies aim to invest in the bonds of companies before they become rising stars – or short them in anticipation of them becoming fallen angels.
According to Franklin Square, “rising stars have generally outperformed similarly rated bonds by an average of 1.5% in the immediate aftermath of an upgrade event.”
Special situations are another type of event-driven strategy that tends to be more effective for credit strategies than for event-driven equity investors. A typical “special situation” may involve a company that’s under short-term financial stress, but has long-term promise. Event-driven credit investors often extend short-term loans to (or buy short-term bonds from) such companies, normally at above-market interest rates and with terms favorable to the lender.
According to Franklin Square, “the average stressed bond issue outperformed the Barclays High Yield Index by an average of nearly 2% per year” over the past decade.
Mergers and Acquisitions
In the equities sphere, mergers and acquisitions (M&A) are the most prominent corporate events. In May, Hillshire Brands – manufacturer of Jimmy Dean sausages, among other popular food products – announced the high-profile acquisition of Pinnacle Foods. Pinnacle’s shares soared, but so did its bonds, rising 9.2% on the day of the merger announcement.
The above example shows that M&A provides event-driven opportunities for fixed-income investors, too. Indeed, since the early 2000s, the bonds of companies receiving merger bids have outperformed their benchmarks by 3% in the month following the proposed merger’s announcement.
Franklin Square’s whitepaper concludes with a list of three keys to event-driven credit strategies:
- Identify market price inefficiencies
- Initiate a catalyst
- Introduce equity-like returns
Since employing event-driven credit strategies requires skill, expertise, and substantial capital, most individuals seeking exposure use investment vehicles such as mutual funds and closed-end funds. In the view of Franklin Square, investors should consider an event-driven credit fund’s focus, its strategy, its expenses, and its risk profile before investing.