At their core, corporate bonds are a “stacked” investment. They combine two key components:

• The Base Return of a Treasury Bond: This represents rate of return provided by the U.S. government.
• The Credit Risk Premium: This additional yield compensates investors for taking on the credit risk of lending to a corporation.

Essentially, when you invest in a corporate bond, you are holding the equivalent of a Treasury bond, with the credit risk premium layered on top. The credit spread reflects the compensation for the possibility that the issuing corporation might default on its debt obligations. This structural layering makes corporate bonds inherently a “stacked” concept.

The credit risk premium fluctuates based on economic conditions, often widening during recessions and tightening during more stable market periods. When economic uncertainty rises, credit spreads tend to expand as investors demand greater compensation for lending to corporations that may struggle to meet their obligations. Conversely, during periods of economic strength, credit spreads often tighten as default risk declines, reducing the excess returns available to bondholders.

Because of these dynamics, corporate bond excess returns have historically been sensitive to changes in economic conditions. In downturns, credit spreads tend to widen and default risks often increase. When growth resumes, spreads typically tighten, and bondholders may benefit from improving corporate fundamentals. The cyclical nature of the credit risk premium suggests that corporate bonds can be an effective but sometimes volatile tool for capturing excess returns over Treasuries.

A “Treasuries plus Merger Arbitrage” strategy follows the same structural framework as a corporate bond, but it swaps out the credit risk premium for a merger arbitrage risk premium. Here’s how the two compare:

• A corporate bond consists of a Treasury bond plus compensation for credit risk.
• A Treasuries plus Merger Arbitrage strategy consists of a Treasury bond plus compensation for merger arbitrage risk.

In both cases, investors start with the foundation of a U.S. Treasury bond. The additional premium reflects compensation for assuming specific risks.

For corporate bonds, this is the risk of corporate default. Merger arbitrage presents a different approach to earning excess returns. Instead of taking on credit risk, investors are compensated for assuming deal risk—the uncertainty that an announced merger or acquisition will close as expected. When a company announces it is being acquired, its stock price typically trades below the agreed-upon acquisition price due to the possibility that regulatory approval, financing concerns, or shareholder objections could cause the deal to fall apart. The spread between the stock’s trading price and the final acquisition price represents the return investors may earn if the deal successfully closes.

This risk premium exists because many investors prefer to avoid event-driven uncertainty. Unlike the credit risk premium, which is tied to corporate solvency and broader economic conditions, the merger arbitrage risk premium is generally linked to the probability of individual deal success. Investors who engage in merger arbitrage seek to systematically capture this spread, which has historically resulted in excess returns that have been relatively stable across different market environments.

While credit spreads expand and contract with the broader economy, merger arbitrage spreads have historically been influenced more by deal flow and regulatory environments than by macroeconomic cycles. This distinction suggests that merger arbitrage could offer an alternative source of return that is less directly tied to credit conditions.

Evaluating whether a Treasuries-plus-merger-arbitrage strategy could serve as a viable substitute for corporate bonds requires an examination of the excess returns each strategy has historically provided. In the post credit crisis period (i.e. since 12/31/2009), the excess return of merger arbitrage – meaning its return above the risk-free rate – has averaged approximately 1.8% annualized. This figure is in line with the historical excess return of corporate bonds over duration-matched Treasuries over the same period, suggesting that, from a return perspective, the two approaches have been comparable alternatives.

However, while returns of the credit risk premium tend to fluctuate with economic cycles, the excess returns of merger arbitrage have historically been more stable. During periods of economic stress, corporate bonds often experience wider credit spreads, reflecting increased default risk. In contrast, the returns from merger arbitrage have generally been tied to deal-specific risks rather than macroeconomic conditions. Although M&A activity has tended to slow during recessions, deals that have already been announced often proceed as planned, allowing investors to capture their expected spreads even in volatile markets.

One key distinction between the credit risk premium and the merger arbitrage risk premium is how they respond to broader market conditions. The credit risk premium, which compensates investors for the possibility of corporate default, has historically been closely linked to the broader fixed-income market and tends to expand and contract with economic cycles. When credit conditions tighten—such as during recessions or financial crises – corporate bondholders typically experience higher spreads and potential losses, as investors demand greater compensation for taking on credit risk. This dynamic often causes the credit risk premium to behave similarly to equities in downturns, as both asset classes are sensitive to deteriorating corporate fundamentals.

The merger arbitrage risk premium, in contrast, has historically shown a low correlation to both equity and credit markets, as its return is primarily driven by deal-specific factors rather than the overall health of corporate balance sheets. While periods of market stress can temporarily impact deal spreads, merger arbitrage returns have generally exhibited lower drawdowns than the credit risk premium. Furthermore, the historical correlation between the credit risk premium and the merger arbitrage risk premium has been relatively low (approximately 0.5 since 2008), suggesting that the risks underlying corporate default and deal completion are distinct. This difference may make merger arbitrage an attractive diversifier for portfolios already exposed to corporate credit risk.

For financial advisors seeking to optimize client portfolios, replacing some corporate bond exposure with a Treasuries-plus-merger-arbitrage allocation may present a compelling alternative. Both strategies rely on a “stacked” approach, where Treasuries serve as the foundation and an additional risk premium generates excess returns. The key difference is that corporate bonds introduce credit risk, while merger arbitrage captures deal risk.

Because the two risk premia behave differently, incorporating merger arbitrage as a substitute for or complement to corporate bonds has the potential to improve portfolio diversification. By introducing a source of excess return that has historically been less sensitive to economic downturns, advisors may be able to reduce reliance on credit spreads while maintaining exposure to the stability of Treasuries.

This approach may also help address behavioral challenges for investors. Many clients are hesitant to allocate to alternatives because it often requires reducing their exposure to familiar asset classes. A stacking strategy allows investors to maintain their fixed-income foundation while layering in an alternative source of return, potentially making it easier to introduce non-traditional investments without disrupting portfolio structure.

Corporate bonds have traditionally been the preferred method for capturing excess returns over Treasuries, primarily due to their embedded credit risk premium. However, a Treasuries-plus-merger-arbitrage strategy follows a similar structural framework while offering an alternative way to generate excess returns. By swapping credit risk for deal risk, investors may be able to earn returns that are historically comparable to corporate bond excess returns, but with a return profile that has tended to be less sensitive to economic cycles.

For financial advisors looking to enhance diversification, manage interest rate sensitivity, and introduce alternative sources of return, merger arbitrage may present an opportunity worth considering. By recognizing merger arbitrage as a distinct risk premium—one that has historically been independent from the credit cycle—advisors may be able to construct portfolios that offer similar return potential to corporate bonds but with meaningful diversification benefits.

For those seeking to refine their fixed-income allocations, replacing credit risk with merger arbitrage could be one way to generate excess returns while improving portfolio resilience across different market environments.