The annualized return is probably about right
In this interest rate environment, a 16.5% annualized return is probably about as good as you’re going to get. It means there’s a lot of risk to the Cigna–Anthem merger. As discussed earlier in this series, the risk-to-reward ratio appears to be something like 1.5:1, which in normal circumstances is a no-brainer. However, that risk-to-reward ratio is understated due to the possibility of UnitedHealth Group (UNH) coming in to take over Anthem (ANTM), leaving Cigna (CI) by itself at the altar.
How do you trade deals like this?
Generally speaking, arbitrageurs aren’t going to have huge positions in deals like this, where there’s so much risk. Arbs make their money by avoiding the minefields, not charging into them. That said, the returns are so good, it may make sense to have a position and trade it around.
The Cigna–Anthem merger deal will be subject to all sorts of headlines that will affect the spread. If President Obama expresses skepticism about the transaction, the spread will blow out as arbitrageurs cut their positions. In these situations, you can add to the position on “scares” and then scale out as people come to their senses. There isn’t going to be a definitive yes or no on this deal for a long, long time. You can make a decent return trading around the position by keeping your head while everyone else is losing theirs.
The trade might be to go between the two deals
Given that you already have an HMO (health management organization) transaction happening between Humana (HUM) and Aetna (AET), the trade might be to switch between the two deals as one gets more attractive than the other. While it’s certainly possible the regulators could allow one deal but not the other, these two deals will probably trade pretty tightly with each other. It probably makes no sense to have both deals on since there won’t be much in the way of diversification benefit. Arbs might decide to set up the most attractive transaction and scale out if the other transaction becomes more attractive.
Other merger arbitrage resources
Other important deals include the Humana (HUM)–Aetna (AET) transaction, which is slated to close in late 2016. For a primer on risk arbitrage investing, read Merger arbitrage must-knows: A key guide for investors.
Investors interested in trading in the healthcare sector should look at the Health Care Select Sector SPDR Fund (XLV).