How Volatility Could Derail the M&A Boom


After the worst two-day decline since mid-November, stocks bounced back on Friday, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average both gaining 0.9%. However, the wasn't enough to put the S&P 500 back in the black for the week, thus putting an end to a seven-week winning streak

Reflecting today's stock gains, the VIX Index , Wall Street's fear gauge, fell 7% to close at 14.17 (the VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days).

The fragile return of the deal
We are just past the midway point in the first quarter and two of the stories that have characterized the start of 2013 are the death of stock market volatility and a spate of corporate dealmaking activity. The two are not unrelated, and both could be derailed.

This week, the VIX Index hit its highest level since the spike that occurred at turn of the year due to the "fiscal cliff," for example. This time around, the Fed was the culprit, but what matters is that it's evidence that the current environment is still prone to fits of "risk on/ risk off." The animal spirits that seem to have emerged from corporate boardrooms to produce a boomlet in mergers and acquisitions could easily go back into hibernation if volatility returns.

Here's one of the mechanisms by which that could happen, courtesy of the Financial Times' John Dizard:

Historically, corporate credit spreads are linked not so much to equity market price levels as equity volatility levels.

Before I explain what that means and why it matters, you can get an idea of just how tight that link is from the following graph, which displays the VIX Index (blue line) vs. the yield spread for one of the benchmark high-yield indexes, the B of A Merrill Lynch Master II Index:

High-yield bonds are a key component in financing leveraged buyout. The spread on high-yield bonds represents the incremental return over same-maturity Treasury bonds that investors require in order to own the bonds. As the graph shows, that spread is back to levels consistent with the LBO bubble of 2006 through mid-2007. In other words, the cost of financing is near a historic low and LBO firms have money to invest -- that's a recipe for deals!

That's fine, but, conversely, the cost of financing is highly vulnerable to the same factors that could jolt stock market volatility -- and though they are lurking, those factors remain many. The signs of an M&A boom are real, but they are fragile.

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned, and neither does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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