Outright Hedged

STRUCTURAL CHANGES IN THE U.S. CONVERTIBLES MARKET: IMPLICATIONS FOR CONVERTIBLE ARBITRAGE

Hedged

Outright

FRANKLIN PARLAMIS PARTNER | [email protected] | JANUARY 2015 ABOUT THE AUTHOR

Franklin Parlamis Partner

Franklin is a leader in the field of convertible and credit arbitrage, ap- proaching the discipline with a combination of intensive analysis, deep experience and innovative thinking. Franklin is Portfolio Manager for the Pine River Convertibles Fund and manages Pine River's San Fran- cisco office. Prior to joining Pine River in 2007, Franklin was a Man- aging Director at Amaranth Advisors from 2000 until 2005 where he co-managed convertible and credit arbitrage portfolios. From 1998 until 2000, Franklin was an attorney at Cleary Gottlieb Steen & Hamilton specializing in sovereign debt restructuring. He received a JD from Yale Law School in 1997, an MS in Statistics from Yale School of Gradu- ate Studies in 1997 and a BA in Mathematics from Princeton in 1993. Franklin was admitted to the partnership in 2010.

Key Contributors: Bo Youn Jo (Strategist) and Dylan Cater (Analyst) provided invaluable assistance with research methodology and data analysis.

Special Thanks: Adam Stein (Portfolio Manager), Steven Vames (Director, Communications), Paul Rich- ardson (Partner, Chief Risk Officer), John Dean (Director, Risk Management), Chris Keller (Trader), Sean Winchester (Trader). ABSTRACT

We identify, isolate and examine several key post-crisis dynamics in the U.S. convertibles market. In particular, we quantify the dominant role that outright investors are playing in the market, and examine differences in the distribution, character and valuation of outright and hedged holdings. We also shed some light on the effects of concentrated ownership and index inclusion on convertible valuations and discuss how these effects may change the convertible arbitrage opportunity set.

3  INTRODUCTION 

In the six years since the 2008 financial crisis, the U.S. convertibles market1 has undergone a number of observable shifts, most notably in who is buying convertibles and how they are using them in their portfolio. Hedge funds, once the dominant players, watched as “outright investors”– typically unhedged and unlev- eraged – grew to dominate many parts of the market. These outright investors brought with them a new set of priorities that have, to some extent, redefined “value” in the convertible space. Whereas hedge funds tend to value how efficiently convertibles express risk (relative to other instruments in a company’s capital structure or the broader market), outright investors instead tend to value convertibles that offer exposure to favored stocks or sectors, are balanced in their equity and credit exposure or are members of an index against which performance can be measured.

Hedge funds that survived the crisis and continued to ply their trade have certainly noticed these changes, at least in a qualitative sense. Yet there seems to be an only marginal understanding of this new market dynamic and even less analytical attention paid to isolating and quantifying the actual changes that have taken place. In the following paper, we set out to better define the new composition of the convertible market and discuss the challenges and opportunities it poses for hedge funds.

We present this paper in two parts. The first is a narrative section that explains the motivation for our study and summarizes its findings. This is followed by an analysis section, which explains our methodology in depth and provides a basis for readers to assess the strength of our findings. It also contains a large number of graphs that offer a “picture” of market changes and opportunities.

THE U.S. CONVERTIBLES MARKET HISTORICALLY

Prior to the 2008 financial crisis, convertibles were largely a hedge-fund asset class. In the years between the bursting of the dot-com bubble and the onset of the financial crisis, for example, hedge fund holdings as a percentage of the total U.S. convertibles market fluctuated between 70% and 80%. Among the factors tending to exclude real-money investors were:

• The basic difficulty of understanding the valuation of convertibles;

• The over-the-counter nature of trading in convertibles; and

• The primary sensitivity of convertibles to equity movements, replicating an exposure that most investors were attempting to complement, rather than grow, in their portfolios.

Traditionally, hedge funds did not hold their convertibles as outright longs; their stated goal was to generate profits that were independent of convertibles’ embedded equity and credit exposures. They did this by pairing long convertible positions with short positions in the underlying equities and, less often, underlying

1 For purposes of this paper and all analyses herein, we consider the “U.S. convertibles market” to include those securities listed from time to time by Barclays Capital as members of the “U.S. Convertibles: Composite” index.

4 credits. Alternatively, they hedged credit exposure at the market level, via a CDS or funded index product.2 These additions produced, at least on paper, a “market neutral” portfolio that hedged out the exposures they didn’t want.

Because its primary sensitivities were hedged, the volatility of a hedge fund convertible portfolio was great- ly diminished, as was its unlevered profit potential. The application of significant leverage to such a portfolio was not only justified in terms of risk, but also mandated from a capital-efficiency standpoint.

This method of trading convertibles – hedged and levered – is what is broadly known as “convertible arbitrage.” It is a classic hedge fund strategy that sources returns by tapping into multiple (and related) alternative betas. Among these alternative betas are expected-return premiums for investing in:

• Unrated securities;

• Securities of smaller-cap issuers, with smaller issue sizes; and

• Complex securities.

In addition to earning a variable risk premium for these alternative beta exposures, convertible arbitrage managers add alpha through security selection3, portfolio construction and superior trade execution.

Because the “prices” of these alternative betas tend to be highly correlated, and also because the features for which holders are compensated all tend to result in diminished security liquidity, the consolidated premium earned by convertible arbitrage managers is often referred to simply as an illiquidity premium, and the practice of convertible arbitrage is said to be “harvesting illiquidity premium.”4 Implicit in this description is the idea that hedge funds purchase convertibles at a discount to their fair value and thus earn a “premium,” and furthermore that this discount results from buyers demanding to be compensated for providing liquidity to sellers (including, importantly, the original issuers of convertibles).

Historically, the “harvesting” description has provided an accurate picture of convertible trading activity. Hedge funds – with liquidity risk in their DNA5 – absolutely demanded an illiquidity discount when they put a bid on new or secondary-market convertible product. At times (such as in 2004 or 2007) this discount was smaller than others. But it was always present.

Largely as a result of this discount, the convertible arbitrage strategy has enjoyed a long – and, to some, perplexing – track record of success. Indeed, as noted in a 2010 Journal of Fixed Income article,

2 Some hedge funds, with limited success, even attempted to hedge volatility exposure via listed single-name and index options, as well as variance swaps and volatility swaps. 3 Examples of convertible selection alpha include choosing good credits or particularly volatile equities, in order to maximize the premium earned over true default risk. 4 We have seen this description multiple places, but perhaps first in Antti Ilmanen’s book, Expected Returns. 5 More so than traditional investors, hedge funds were (and remain, to a lesser extent) subject to shortening of their capital duration. Their debt capital was almost exclusively sourced from short-term repo markets and, importantly, was blind to any hedges the funds may have entered. The duration of their equity capital was eroded by end investor demands for enhanced liquidity.

5 “... the magnitude and persistence of this strategy’s performance over the years presents a puzzle in fi- nance. If transaction costs are low, and assuming a relative abundance of human and financial capital to be devoted to the strategy, the abnormal returns earned by convertible arbitrage funds in their early history should have quickly disappeared over time.” 6

The answer to the puzzle – at least in the opinion of the article’s authors – is that convertible arbitrage managers have been receiving systematic compensation for illiquidity risk.

The returns of the average convertible arbitrage manager over time are impressive. The Credit Suisse Convertible Arbitrage Hedge Fund Index has underperformed the S&P 500 over the last 20 years (7.1% vs. 9.5%), but with a higher Sharpe Ratio (0.66 vs. 0.45) and, significantly, a low correlation (36%) that com- pares very favorably to the 57% equity correlation of the set of hedge fund strategies in the broader Credit Suisse Hedge Fund Index.

Unfortunately, the experience of many end investors in convertible arbitrage is somewhat worse than might be expected from the index’s success. We attribute this to the fact that they have demanded liquidity of the strategy, rather than providing liquidity to it. In other words, many end investors subscribed at a time of overall positive flows (when market illiquidity premium was low), and redeemed at a time of overall negative flows (when market illiquidity premium was high), rather than vice versa. This behavior (understandable, given the level of intermediation in the business of investing) is absolutely at odds with the underlying strategy goal of “harvesting illiquidity premium.” More than anything else, we blame this behavioral tension for the strategy’s negative market perception.

THE U.S. CONVERTIBLES MARKET TODAY

In the financial crisis of 2008, many traditional convertible arbitrage investors were blown out of the asset class. Their capital-duration deficiencies proved too much to handle, and the environment frankly tested the limits of any liquidity-provision strategy, particularly one that was not broadly understood to be a liquidity provision strategy in the first place.

While the strongest players survived and even thrived in the aftermath, the amount of capital allocated to convertible arbitrage has dramatically diminished from its peak.7 Reasons for this include:

• An emphasis among end investors on directional strategies intended to benefit from govern- ment sponsorship of risk taking through easy monetary policy;

• Massive leverage aversion among end investors, regardless whether in the context of a directional or a hedged strategy; and

• The overall richening of convertibles.

6 A Liquidity Based Explanation of Convertible Arbitrage Alphas (G Batta, G Chacko, BG Dharan, Journal of Fixed Income, 2010). 7 According to BarclayHedge, peak strategy AUM was $58 billion in 2004, compared with roughly $30 billion today.

6 Consistent with these themes, the predominant buyers of convertibles since the end of the financial crisis have been outright investors. They now own an estimated 65% of all U.S. convertible assets (up from 20- 30% before the financial crisis). Hedged holdings have concomitantly dropped. Unlike hedge funds, the goal of outright investors is not to harvest illiquidity premium or to produce market-neutral returns. Rather, it is to buy assets that reflect traditional risks – credit and equity – in a single instrument.

In light of this major shift in holdings, we set out to analyze the new convertible landscape. Our goal was to understand – in numbers as well as words – how outright investors have changed the convertible opportunity set.

In essence, we wanted to see whether there is still room for arbitrage. Throughout the extended period of unconventional monetary policy in the United States, it is clear that most liquidity demands have been initiated by outright convertible buyers. As a result, the asset class on the whole (measured by Barclays' data) has spent a decent portion of the last four years trading above fair value. Against this backdrop, it is reasonable to wonder whether there is, in fact, any illiquidity premium left for convertible arbitrageurs to harvest.

 METHODS AND FINDINGS 

Our analysis relied on data from three independent sources:

• Institution-level holdings data from SEC Form 13F filings (as supplemented by institution type data from Bloomberg LP);

• Issue-level risk and valuation data from Barclays Capital; and

• Convertible index constituent data from Thomson Reuters.

We combined these data sources in different ways to draw conclusions about the current marketplace.

HEDGE FUND VERSUS OUTRIGHT HOLDINGS

To begin, using SEC and Bloomberg data, we constructed two portfolios of convertible holdings:

• the Hedge Fund Portfolio; and

• the Outright Portfolio.

The Hedge Fund Portfolio comprises all convertible securities reported held on Form 13F, as of late 2014, by institutional investors that Bloomberg identifies as “hedge fund managers.” In other words, it represents what end investors might own if they gave a capital-weighted amount of money to each hedged owner of U.S. convertibles. The Outright Portfolio represents the same thing, only for institutional investors identi-

7 fied as “investment advisors.” It represents what end investors might own if they gave a capital-weighted amount of money to each outright owner of U.S. convertibles.

Are Hedge Fund Holdings Significantly Different than Outright Holdings?

Our first goal was to understand the overlap of the Hedge Fund and Outright Portfolios. If we imagine for a moment that the portfolios are identical – and if one believes, as we do, that outright investors have been paying up for convertibles in order to deploy excess liquidity – then it would stand to reason that convertible arbitrage managers held little, if any, illiquidity premium in their current portfolios.

As expected, the data suggests instead that the Hedge Fund and Outright Portfolios are materially disjoint. The main findings supporting this conclusion are:

• A large skew in the distribution of Hedge Fund holding percentages across issues, with some 34% of the entire U.S. convertible market effectively unheld by hedge fund managers;

• A large variance in the percentage of unrated securities in the two portfolios: 41% unrated in the Hedge Fund Portfolio, versus 19% in the Outright Portfolio; and

• A large difference in the average issue size held in the two portfolios: $288 million for the Hedge Fund Portfolio, versus $401 million for the Outright Portfolio (market-wide average issue size is $360 million).

These latter portfolio differences (unrated holdings and issue sizes) align with the alternative beta sources that contribute to the illiquidity premium. It seems, then, that hedge funds are still attempting to deliver illiquidity premium to their end investors. The effort shows in their visible portfolios.

Despite this, there is still a decent amount of overlap between the Hedge Fund and Outright Portfolios. This could be because some hedge funds are using convertibles directionally. It also could be because some hedged holders are blending a “front-running” strategy with a more traditional liquidity-provision strategy,8 or are simply making earnest attempts to improve the liquidity and balance of their underlying portfolios, even if that means resorting to paper with an “ordinary” risk profile.

In our analysis, we eliminated the overlap between the Hedge Fund and Outright Portfolios by removing those holdings which, as a percent of each portfolio’s total, were already represented in the other portfolio. This resulted in two new, smaller portfolios: the “Unique” Hedge Fund Portfolio and the “Unique” Outright Portfolio. We found that:

• The Unique Portfolios were 45% as large as the original portfolios (i.e., the Hedge Fund and Outright Portfolios are about 55% overlapping); and

8 A front-running strategy attempts to earn short-term profits by purchasing convertibles not on the basis of cheapness, but rather on the basis of perceived demand in the near future, especially if the demand is price-indifferent. Front-running is a distinct—and perfectly viable—hedge fund strategy. Its essential profit sources and risks, however, are nearly the opposite of illiquidity-premium harvesting.

8 • As one would expect, the variance in the percentage of unrated securities is even more severe in the Unique Portfolios (56% for the Unique Hedge Fund Portfolio, versus 11% for the Unique Outright Portfolio), as is the difference in average issue size ($229 million, versus $491 million).

We conclude that, in large part, hedge funds in the convertibles space are delivering exposure to the traditional alternative betas (and associated alphas) that have historically driven performance for the convertible arbitrage strategy. However, in the aggregate, they are also delivering hedged exposure to a sub-portfolio that is accessible via a lower-fee, unhedged approach to the asset class. Accordingly, end investors choosing between outright and hedge-fund exposures to convertibles should consider:

• Their appetite for the directional exposures of the Outright Portfolio;

• The relative valuations and exposures of the Unique Portfolios; and

• Whether hedge fund managers can add enough alpha to compensate for higher fees on the overlapping portion of the portfolios.9

Are Hedge Funds Being Rewarded for the Extra Risks in their Portfolio?

Our second goal was to understand the valuation of the different portfolios, and in particular determine whether hedge funds are being rewarded for the illiquidity risk they bear. To assess this, we turned to our second data source, Barclays’ issue-level risk and valuation data. By applying this data to the Hedge Fund and Outright Portfolios, we were able to generate traditional credit risk measures for the two portfolios as of January 2015.

We found that, as compared with the Outright Portfolio, the Hedge Fund Portfolio has:

• A higher implied credit spread (502 basis points, versus 385 basis points);

• A shorter expected life (2.7 years, versus 3.9 years); and

• A lower overall credit quality (Ba3, versus Ba2).10

We next adjusted the implied spread on the Hedge Fund Portfolio in order to penalize it for its lower credit quality, as well as reward it for its shorter term. Net of these adjustments, we found that the Hedge Fund Portfolio trades with an extra 117 basis points of credit risk-adjusted spread versus the Outright Portfolio.11 We refer to this extra spread as the “normalized excess spread” of the Hedge Fund Portfolio. This normalized excess spread, at 117 basis points, widened in the fourth quarter of 2014 from an initial level of 91

9 Much of this alpha will be a function of investment skill. However, some of the alpha can be structural. For example, smaller, more nimble vehicles can outperform larger competitors due to their ability to more easily grow or reduce portfolio exposures on available market liquidity. 10 Our credit quality methodology is explained in the Analysis section. Due to the higher percentage of unrated securities in the Hedge Fund Portfo- lio, the manner in which unrated credits are mapped to rated credits has a significant influence on the overall credit quality differential. 11 This number is the same as the actual implied spread differential between the two portfolios, but only because the term and ratings adjustments happened to be precisely offsetting. Please see the Analysis section for a description of the methodology.

9 basis points.

We also calculated the normalized excess spread of the Unique Hedge Fund Portfolio versus the Unique Outright Portfolio. This spread reflects how much extra credit risk-adjusted compensation the unique elements of the Hedge Fund Portfolio receive over the unique elements of the Outright Portfolio. As one might expect from the substantial overlap (which earns zero excess spread by definition), the unique spread was on the order of double the full portfolio spread. It ended the quarter at 251 basis points, out from 223 basis points a quarter earlier.

We offer the normalized excess spread metric (the calculation and limitations of which are explained in greater detail in the Analysis section of this paper) as a measure of the illiquidity risk premium being earned by hedge funds on their portfolios.

CONCENTRATED HOLDINGS

We next turned our attention to holder concentration risk in the U.S. convertibles market. A significant contributor to the severity of the 2008 convertible market drawdown was that individual hedge funds had amassed substantial positions in particular convertible issues.12 This circumstance resulted in an abnor- mally large 2008 increase in the illiquidity risk premium in the convertible market vis-à-vis other corporate credit markets in the United States.

Are Convertible Holdings Concentrated?

To assess concentration risk, using SEC data, we looked at the aggregate holdings of the top five reported holders in each convertible issue. We found that:

• 45% (by market value) of U.S. convertible issues are more than 50% controlled by their top five reported holders; and

• 80% of U.S. convertible issues are more than 30% controlled by their top five reported holders.

This is a significant level of holder concentration. To put it in context, consider that roughly 4% of the U.S. convertible market turns over on a monthly basis in today’s relatively unstressed market.

Do Concentrated Holdings Carry an Illiquidity Premium?

Because chunky holdings are very difficult to sell, they should, in a rational market, carry an even larger illiquidity premium than your average issue. However, we found that precisely the opposite is true in today’s U.S. convertibles market. As before, we merged Barclays’ risk and valuation data with the existing concentration analysis. The results:

12 It was not uncommon to see one or two large convertible hedge funds owning in excess of 50% of an issue’s size. When trouble arose, these issues proved very difficult to sell, even in small size, as rational buyers did not want to stand in front of massive supply.

10 • For the U.S. convertibles market as a whole, investors get paid an implied spread of 421 basis points for a portfolio with weighted average credit quality slightly below Ba2; but

• For the 15% of the convertible market with top-five holder concentration above 70% (the “Tightly Held Portfolio”), investors accept a spread of 370 basis points for a portfolio with weighted average credit quality slightly below Ba3.

In other words, concentrated holders get paid less spread for more risk. In addition, they have a longer-life portfolio. As a result, the Tightly Held Portfolio enjoys a normalized excess spread of –153 basis points versus the market as a whole. This negative spread more than doubled in the fourth quarter of 2014, from a starting level of –76 basis points.

We conclude from this data that concentrated holdings trade at a substantial premium to the rest of the U.S. convertibles market and reflect a familiarity or defense premium,13 rather than an illiquidity discount. Convertible investors should demand compensation for, or hedge against, the threat of asset-class conta- gion should concentrated holders become sellers.

INDEXING

Our final inquiry concerns how indexing might be affecting the convertibles market. The rise of outright investors in U.S. convertibles has brought with it a rise in the use of indexes as measures of their performance. The impact of index inclusion on the valuation of individual convertible issues – although understood to be significant by market participants – has yet to be systematically studied.

Are Indexes Large Enough Relative to Market Demand?

The most watched indexes of global convertible performance are the Thomson Reuters Global Convertible Indices.14 Among these, by far the most important to U.S. convertibles traders is the U.S. Focus Convertible Index (the Focus Index).

The Focus Index is “selected to contain Balanced issues”.15 As a practical matter, an issue is “Balanced” if its price is relatively close to par and its premium is not too large.16 These types of issues offer, not sur- prisingly, a balance between downside protection (when the convertible can be treated as a fixed income instrument) and upside equity participation (when the conversion option can be exercised). Because the

13 A holder might pay a “familiarity premium” if they have money to invest and are more confident in their research on an existing name than in new research on another name. A “defense premium” might emerge when a holder staunches negative price action in a large position through defensive buying. 14 These were historically known as the UBS Global Convertible Indices, and were rebranded when Thomson Reuters acquired the UBS index business in July of 2014. Information on the administration of these indexes, including selection processes and criteria, can be found at the following link: http://financial.thomsonreuters.com/content/dam/openweb/documents/pdf/financial/convertible-indices-methodology.pdf (we refer to this document as “the Rules”). The Thomson Reuters Global Convertible Indices are divided geographically into Regions. Both the Global and Regional Indexes are further refined into sub-indexes, which contain issues with particular features or characteristics (e.g., investment grade issues). 15 The Rules, Section 3.3.1.1. 16 A detailed description of what qualifies a bond as “Balanced” is in Section 3.3.1.4 of the Rules.

11 stated goal of most outright investors is to offer just such a balanced return profile, and also because the Focus Index can be used as a performance benchmark for outright investors, inclusions to and exclusions from it often lead to material price shifts in the affected issues as outright investors adjust their portfolios to better track the index.

To help understand the effects of indexing on the U.S. convertibles market, we followed the Focus Index, using Thomson Reuters’ historical constituent changes and Barclays’ risk and valuation data. We found that:

• Over the last two years the amount of convertible market value in the Focus Index is unchanged, at about $38 billion (or 17.5% of the total market).

• Over that same time frame, the amount of assets invested in our sample set of convertible mutual funds and ETFs has increased by 70%.17

Today, the money invested in these convertible mutual funds and ETFs alone is sufficient to buy 57% of the entire Focus Index. This figure is up from 33% at the beginning of 2013. Our sample set of mutual funds and ETFs by no means represents the entire universe of outright convertible buyers. If its growth rate is representative of the growth rate of the outright universe as a whole, there appears to be significant risk that crowding is affecting the valuation of securities in the Focus Index.

Do Index Constituents Trade at a Premium?

To assess the potential impact of index demand, we tracked Focus Index credit metrics in a similar manner as before. We found that:

• Although the Focus Index historically contained higher-quality issues, its credit-quality advantage has disappeared over the past two years, and it now has a weighted-average credit quality that is slightly lower than the rest of the market (and an equal percentage of unrated issues);

• The expected life of the Focus Index stands where it was two years ago, roughly a half year longer than the market on average; and

• The implied credit spread on the Focus Index stands at 252 basis points, versus 457 basis points for the rest of the market.

After adjusting for credit-quality and term differences, at the beginning of 2015 the Focus Index trades at a normalized excess spread of –242 basis points to the rest of the market. That spread stood at –188 basis points one quarter earlier.

One other metric that is often used to assess valuation is the “paydown ratio” (or similar measure that gets at the same concept). Simply put, a convertible’s paydown ratio is the ratio of its premium to the total excess

17 We found 17 open-ended dollar-denominated convertible mutual funds and ETFs. The methodology by which we arrived at this sample set is detailed in the Analysis section.

12 cash flows it is expected to produce over its life. When a convertible trades to a paydown ratio of 1, it is very close to its arbitrage-free boundary, because it is expected to pay down all of its premium before it either converts to equity, matures or is rendered a superior claim to equity in a bankruptcy proceeding.

A high paydown ratio tends to indicate that a convertible is very far from its arbitrage free bound, and therefore very far from where one might expect to find crossover buying interest from hedge funds. We took a look at the paydown ratio of the Focus Index, to get a sense of where other buyers might step in if the traditional sources of outright interest were to dry up. We found that:

• At the beginning of 2015, the paydown ratio of the Focus Index stands at around 10, mean- ing that 90% of the Focus Index’s premium would need to evaporate before a true arbitrage condition arose;

• This Focus Index paydown ratio more than doubled in 2014, after spending most of 2013 hovering between 4 and 4.5; and

• The paydown ratio of the rest of the U.S. convertibles market has been relatively constant over the last two years, ranging between 2.25 and 2.5. It currently stands at the bottom end of that range.

Although the paydown ratio is a little more difficult to digest than customary credit metrics, it has proven a helpful concept for convertible arbitrageurs over the years.18 It would be an oversimplification to suggest that simple comparison of paydown ratios can tell the complete story of two portfolios; many factors (price point and credit quality being the most significant) can justify a variance. However, when one portion of the market (the Focus Index) trades at such a dramatically different paydown ratio from another, it speaks to a large separation of buyer classes.  CONCLUSION 

This paper looked at the impact of three factors in the U.S. Convertibles market:

(i) Outright ownership;

(ii) Concentrated ownership; and

(iii) Index inclusion.

We found that these three factors tended to produce increasing levels of richness, according to our normalized excess spread measure. At the beginning of 2015, the portfolio of convertibles held by outright investors traded over 1% rich per annum to the portfolio of convertibles held by hedge funds. This richness increased to just over 2.5% per annum when we removed the overlap in the two portfolios and looked only

18 The basic reason for this is that it eliminates any reliance on credit/equity correlation (or, more specifically, the lack thereof) in valuing a convertible. A convertible that is trading at a paydown ratio of 1 need not exhibit any convexity at all relative to equity in order to justify its valuation, and so an arbitrage position amounts to an “option” on that convexity.

13 at unique outright and hedge fund holdings. Finally, tightly-held convertibles and convertibles in the Focus Index traded about 1.5% and 2.5% rich per annum, respectively, to the rest of the market. These richness levels, as well as their movements over the prior quarter, are summarized in the chart below:

NORMALIZED EXCESS SPREAD

SUBJECT PORTFOLIO TARGET PORTFOLIO END OF 3Q 2014 END OF 4Q 2014

OUTRIGHT HEDGE FUND (91) (117) UNIQUE OUTRIGHT UNIQUE HEDGE FUND (223) (251) TIGHTLY-HELD REST OF MARKET (76) (153) FOCUS INDEX REST OF MARKET (188) (242) SOURCE: SEC, THOMSON REUTERS, BLOOMBERG, BARCLAYS CAPITAL, PINE RIVER CAPITAL

In addition to the normalized excess spread measure, traditional cash flow measures of convertible valuation tend to confirm the overvaluation of certain parts of the market, in particular Focus Index convertibles.

As a result, investors who choose to access the convertibles market via an outright manager are paying a fairly large premium to do so. In exchange for that premium they do receive enhanced liquidity, both in their vehicles and in certain of the vehicles’ underlying holdings. This enhanced liquidity, however, is only as good as one’s willingness to use it, and several factors (including the very high levels of holder concentration) have recently increased the risk that the liquidity advantage could turn to a disadvantage very rapidly.

On the other hand, investors in hedge funds are already receiving a substantial illiquidity premium, one that moved higher in the fourth quarter of 2014. There is a smaller, but still material, portion of the U.S. convertibles market that reflects this premium. Most hedge funds are now designed, in their liquidity terms, to withstand mark-to-market volatility, to warehouse and earn over time the illiquidity premium priced into their market.

Investors with the willingness to extend capital for some time (1-2 years) should consider accessing this premium, which comes close in certain cases to doubling the available credit spread. This extra spread can either be conceived of as a margin of safety for higher realized defaults in the future, or as a premium earned for longer-term capital and for investing in many cases without rating agency imprimatur.

14  ANALYSIS 

15 OUTRIGHT VERSUS HEDGED HOLDINGS

In their 2014 review of global convertible market trends, Greenwich Associates found that:

• 54% of survey respondents were “hedged” investors, versus 46% “outright” investors.

• 35% of all convertibles were held by “hedged” investors, versus 65% by “outright” investors.

In other words, even though hedge funds still represent the majority of investors in convertible assets, they hold a significant minority of those assets by market value. This continues a trend in place since the 2008 financial crisis (see chart below).

HEDGED HOLDINGS (AS % OF TOTAL CONVERTIBLE MARKET) HEDGED HOLDINGS FIGURE 1 (AS % OF TOTAL CONVERTIBLE MARKET) 100%

80%

60%

40%

20%

0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 SOURCE: GREENWICH ASSOCIATES

The only post-crisis uptick in hedged holdings was coincident with the only post-crisis stall in equity index performance (2011). This suggests that outright convertible strategies (as well as front-running strategies that rely on outright support) may be even more highly correlated with equities than theoretical deltas imply.

We conducted our own analysis of the convertible holdings distribution. While the Greenwich analysis is global and based on survey data, our analysis is based on reported holdings of U.S. convertibles from SEC Form 13F filings. By accessing this 13F information on a Bloomberg terminal or data feed, one also receives Bloomberg data on each holder’s “institution type.”

We aggregated the most recent holdings information (late 2014) for each issue in the U.S. convertibles universe. We made two adjustments to the raw data:

• When the reported holdings of an issue were greater than 140% of the issue’s size, we scaled the reported holdings down pro rata so that the total percentage held was equal to 83% of issue size, the average percentage of an issue’s size that was visible through 13F filings.19

19 In essence, we assumed in these cases that there was some reporting error, or that a partial retirement of bonds (such as through a tender) had occurred in between the 13F filings (which are generally updated quarterly) and observation of the issue-size data (which occurs monthly). Anecdot-

16 • When the reported holdings of an issue were greater than 100%, but less than 140%, of an issue’s size, we scaled the reported holdings down pro rata so that they were between 100% and 125% of the issue’s size (essentially, we narrowed the excess window above 100%).20

We chose the latter scaling so as to make the total visible short base in the convertibles market roughly equal to the estimate at which we arrived independently through prime broker surveying. Through discus- sions with our prime brokers, we estimated that the U.S. convertibles market has a 3% short base.

As noted above, by this method we were able to find homes for 83% of all outstanding U.S. convertibles (the “visible market”). We were unable to obtain any holdings data at all for 5.5% of the U.S. convertibles market by value; the rest of the non-visible market is accounted for by issues for which we had some, but not all, of the holdings data.21 The holdings we found are distributed across institution types as follows:

HOLDINGS OF U.S. CONVERTIBLES BY INSTITUTION TYPE FIGURE 2

HOLDINGS OF US CONVERTIBLES BY INSTITUTION TYPE

HEDGE FUND MANAGER NOT VISIBLE HEDGE FUND MANAGER 21% 26% INVESTMENT ADVISOR

OTHER OTHER 8%

NOT VISIBLE

INVESTMENT ADVISOR 48%

SOURCE: SEC, PINE RIVER CAPITAL

ally, we confirmed that this was indeed the case for several issues with which we were familiar. 20 We feel that this range of reported holdings reflects legitimate excess ownership as a result of shorting activity. Anecdotally, most bonds that we observed in this category are known popular shorts. 21 Certain issues have no holdings data at all because the SEC does not require every single convertible issue to be reported on Form 13F. The rest of the non-visible universe is likely held by retail or other non-institutional investors or non-13F filers.

17 If we were to redistribute the “Not Visible” basket pro rata among the known institution types (something we do not do in generating our histograms or valuation statistics below, due to the potential for bias), we would end up estimating that roughly one-third of U.S. convertibles are held by hedge fund managers, and roughly two-thirds are held by investment advisors and other outright investors (such as insurance compa- nies). This result would be broadly consistent with the above Greenwich survey results, which found that convertible holdings were distributed 35/65 between “hedged” and “outright” investors.

Below we express the market value of U.S. convertible issues for which the reported percent held by investment advisors falls into certain buckets (0-10%, 10-20%, etc. of the total issue size). This information is alternatively expressed, on the right axis, as a percentage of all U.S. convertible market value.

HOLDING CONCENTRATION HISTOGRAM: INVESTMENT ADVISORS FIGURE 3 HOLDING CONCENTRATION HISTOGRAM: INVESTMENT ADVISORS 40 18% 31 30 31 30 23 24 14% 20 % OF USD 20 14 15 9% ALL (BN) 13 MV 10 4 4 5% 0 - - 0 0%

PERCENTPERCENT OF OF ISSUE ISSUE OWNED OWNED BY BY INVESTMENT INVESTMENT ADVISORS ADVISORS SOURCE: SEC, PINE RIVER CAPITAL

The shape of the above distribution is not that surprising – roughly symmetric about its mean of 48%. In the histogram below, we express the same information, only this time for hedge fund managers (instead of investment advisors).

HOLDING CONCENTRATION HISTOGRAM: HEDGE FUND MANAGERS FIGURE 4 HOLDING CONCENTRATION HISTOGRAM: HEDGE FUND MANAGERS 76 80 36%

60 27% % OF USD 40 27 26 18% ALL (BN) 24 19 MV 13 11 20 7 6 9% 1 - - - - 0 0%

SOURCE: SEC, PINE RIVER CAPITAL PERCENTPERCENT OF OF ISSUE ISSUE OWNED OWNED BY BY HEDGE HEDGE FUND FUND MANAGERS MANAGERS

18 The hedge fund manager distribution is skewed, with some 34% of all U.S. convertible market value in the 0-10% reported holdings bucket. Recall that these histograms only cover the visible market. Actual bucket sizes would be larger, and the distribution shifted to the right, if we were to prorate non-visible holdings among the known institution types. In particular, the 0-10% bucket for hedge funds would cover less than 34% of the market.

We next constructed portfolios to represent hedge fund and outright holdings. We constructed the Hedge Fund Portfolio by combining the 13F holdings information for the “hedge fund manager” institution type with Barclays’ year-end data on each security in the U.S. convertible universe.22 We constructed the Out- right Portfolio similarly, only for the “investment advisor” institution type.

Summary statistics for the Hedge Fund and Outright Portfolios are below:23

FIGURE 5 HEDGE FUND OUTRIGHT PORTFOLIO PORTFOLIO

PRICE 134 117 PARITY 114 91 COUPON 3.1% 3.6% PARITY YIELD 0.6% 0.9% RHO (1.5) (3.0) EXPECTED LIFE 2.7 3.9 CREDIT QUALITY 13.0 12.0 UNRATED PORTION 41% 19% OAS 502 385 SOURCE: SEC, BARCLAYS CAPITAL, PINE RIVER CAPITAL

Running through these statistics, we see that the Hedge Fund Portfolio represents an in-the-money option (parity 114), while the Outright Portfolio represents an out-of-the-money option (parity 91). As a result, the average Hedge Fund Portfolio holding trades with a higher price and lower point premium than the average Outright Portfolio holding. Hedge Funds also own slightly lower coupons, but they compensate for it by avoiding underlying equities with big dividend yields.

The Hedge Fund Portfolio is a shorter-term portfolio with less credit spread risk than the Outright Port- folio. This makes sense given the varying price points of the two portfolios. Based on the rho measure, the

22 Form 13F information is updated quarterly in most cases. The Hedge Fund and Outright Portfolios are thus accurate as of the end of the third quarter of 2014. It is possible that trading activity during the fourth quarter may have altered the profiles somewhat, but we believe the portfolios should still be broadly representative of hedge fund and outright holdings. 23 Price, parity, coupon and parity yield are all face-weighted portfolio averages. Parity Yield is the annual dividend yield on the underlying conversion shares (or, if lower, the annual dividend yield from which dividend protection begins), expressed as a percent of the convertible’s face amount. In other words, it is the “coupon” that convertible holders forego by holding the bond instead of the underlying equity. Rho and Expected Life are dollar-weighted portfolio averages. Credit Quality, Unrated Portion and OAS are dollar-rho-weighted portfolio averages.

19 Hedge Fund Portfolio levered at 2.0x would carry about as much orthogonal credit risk (or basis risk, if the fund has hedged its credit exposure) on equity capital as the unlevered Outright Portfolio.

Below are the price-point distributions of the Hedge Fund Portfolio and the Outright Portfolio.

PRICE DISTRIBUTION: HEDGE FUND MANAGER PORTFOLIO FIGURE 6 PRICE DISTRIBUTION: HEDGE FUND MANAGER PORTFOLIO

30% 25% % OF 20% HOLDINGS 15% 10% 5% 0%

PRICE OF CONVERTIBLE (% OF PAR) SOURCE: SEC, BARCLAYS CAPITAL, PINE RIVER CAPITAL PRICE OF CONVERTIBLE (% OF PAR)

PRICE DISTRIBUTION: OUTRIGHT PORTFOLIO FIGURE 7 PRICE DISTRIBUTION: INVESTMENT ADVISOR PORTFOLIO

30% 25% % OF 20% HOLDINGS 15% 10% 5% 0%

PRICE OF CONVERTIBLE (% OF PAR) SOURCE: SEC, BARCLAYS CAPITAL, PINE RIVER CAPITAL PRICE OF CONVERTIBLE (% OF PAR)

It is evident from the above (as well as the summary statistics) that a far greater portion of the Hedge Fund Portfolio is invested in above-par assets that should benefit from higher equity volatility and traditional skew. However, these above-par assets are also more sensitive to market frictions, such as borrow fees and financing spreads.

To generate the credit quality metric for the portfolios, we coded the Moody’s alphanumeric bond ratings (which we took from the Barclays data) into numbers and took dollar-rho-weighted portfolio averages.24

24 Aaa=1, Aa1=2, Aa2=3, Aa3=4, A1=5, A2=6, A3=7, Baa1=8, Baa=9, Baa3=10, Ba1=11, Ba2=12, Ba3=13, B1=14, B2=15, B3=16, Caa1=16.5, Caa2=17,

20 The tricky part is dealing with issues that are not rated. The percentage of unrated holdings (the “Unrated Portion” in the chart) is substantially higher in the Hedge Fund Portfolio than in the Outright Portfolio. To generate the credit-quality statistics in the chart above, we treated unrated issues as if they were B1-rated issues (score = 14). We did this because B1 is the rating cohort the implied OAS (Option-Adjusted Spread) of which best matched the exhibited implied OAS of the unrated cohort for the past 12 months.25 In other words, the market has been trading unrated convertible paper as if it were B1 convertible paper and no premium exists for taking unrated credit risk.

We believe this method is conservative (i.e., that we are erring on the side of underestimating the credit quality of unrated issues) as a result of the assumption that the 2014 U.S. convertibles market offered no premium for taking unrated credit risk. However, because the decision how to rank unrated issuers is an important one, below we offer a sensitivity chart for a variety of credible surrogate rating categories.

FIGURE 8 HEDGE FUND INVESTMENT ADVISOR WITH UNRATED EQUAL TO: PORTFOLIO PORTFOLIO DIFFERENCE CREDIT QUALITY CREDIT QUALITY Ba2 12.2 11.6 0.6 Ba3 12.6 11.8 0.8 B1 13.0 12.0 1.0 B2 13.4 12.2 1.2 B3 13.8 12.4 1.5 SOURCE: SEC, BARCLAYS CAPITAL, PINE RIVER CAPITAL

We see from the above that the Hedge Fund portfolio is likely somewhere between 0.6 and 1.5 rating notch- es lower quality than the Outright Portfolio (and both are in the vicinity of Ba2 or Ba3).

Interestingly, empirical data on historical credit losses for the unrated cohort is difficult to come by. We were able to find one study (pre-1962!) that put them somewhere in between realized losses on the BBB and BB cohorts (which would imply a score of around 10.5 in our coding). It seems likely that the rating agencies might have performed such studies, and even more likely that they would have made them pub- licly available if those studies showed significantly higher credit losses for the unrated cohort than for the various official rating categories.

To add a little more flavor to the discussion, and to show the type of price action that can occur in the unrated cohort when a liquidity demand is made, below we show the distribution of implied OAS among the unrated U.S. convertibles cohort, at the beginning and the end of the fourth quarter of 2014.

Caa3=17.33, Ca=18, C=19, D=20. Further refinement of this coding is warranted. For example, one might consider an alternative coding that scales, rather than linearly, with the observed trading spreads for each rating cohort or, alternatively for certain purposes, with the observed level of historical default losses in each cohort. We do not believe such refinements would materially affect the results of this analysis, however. 25 “Best matched” means that B1 was the center rating in the three-cohort band that minimized the sum of squared deviations between the 12-month trailing OAS for the unrated cohort and the three-cohort band.

21 First, the distribution as of September 30, 2014:

IMPLIED OAS HISTOGRAM: UNRATED COHORT FIGURE 9 IMPLIED OAS HISTOGRAM: UNRATED COHORT 20%

% OF 15% COHORT 10% SPREAD RISK 5%

IMPLIEDIMPLIED OAS BUCKET OAS BUCKET SOURCE: BARCLAYS CAPITAL, PINE RIVER CAPITAL

Now the distribution as of December 31, 2014:

IMPLIED OAS HISTOGRAM: UNRATED COHORT FIGURE 10 IMPLIED OAS HISTOGRAM: UNRATED COHORT 20%

% OF 15% COHORT 10% SPREAD RISK 5%

IMPLIEDIMPLIED OAS BUCKET OAS BUCKET SOURCE: BARCLAYS CAPITAL, PINE RIVER CAPITAL

The dollar-rho weighted average implied OAS of the unrated cohort went from 420 to 580. The move in the rated cohort was about half as severe, from 275 to 357. Although it is possible that the hazard rate or loss given default expectations for the unrated cohort might have moved sufficiently higher to justify such a spread differential, it seems more likely that a significant portion of the extra widening amounts to higher compensation for unrated illiquidity risk. As we already know, this risk is expressed in the Hedge Fund Portfolio, far more than the Outright Portfolio.

Further support for the hypothesis that spread widening in U.S. convertibles is mostly, or even all, about expansion of the illiquidity premium comes from the very-liquid high-yield CDX market. The total return on high-yield CDX exposure in the fourth quarter of 2014 was +2.1%.26 So, even as individual bond issues sold off, the most-liquid access point to credit – the synthetic index – rallied.

26 North America High Yield 5Y USD Unfunded Barclays Credit Index

22 The overall difference in the implied OAS statistic between the Hedge Fund Portfolio and the Outright Portfolio is 117 basis points. This difference widened materially in the fourth quarter of 2014 (see below), from a level of 69 basis points.

PORTFOLIO OAS: HEDGE FUND VS. OUTRIGHT PORTFOLIO FIGURE 11 PORTFOLIO OAS: HEDGE FUND VS. OUTRIGHT PORTFOLIO HEDGE FUND PORTFOLIO OUTRIGHT PORTFOLIO 550 502 473 500 453 450 385 400 362 363 333 350 293 300 250 Sep-14 Oct-14 Nov-14 Dec-14 SOURCE: SEC, BARCLAYS CAPITAL, PINE RIVER CAPITAL

We propose a two-step transformation of the OAS metric on the Hedge Fund Portfolio in order to make it comparable to the OAS metric on the Outright Portfolio.27

1. We adjust for the expected life difference between the two portfolios by adding to the OAS of the Hedge Fund Portfolio the amount of linearly interpolated steepness in the High-Yield CDX term structure;28 and

2. We adjust for the credit quality difference by subtracting from the OAS of the Hedge Fund Portfolio the appropriate amount of linearly interpolated spread differential between the BB and B cohorts in the Barclays U.S. Corporate High-Yield Index.29

Our goal here is to bring two portfolios onto a common ground so that we can assess whether one trades with an illiquidity premium (or other premium) relative to the other. We refer to this transformation as nor- malization of one portfolio’s OAS to another, and we refer to the resulting OAS spread as the “normalized excess spread” of one portfolio relative to another.

27 We believe that normalized credit spreads are the most objective way to compare two convertible portfolios. There are three reasonable approaches: (1) compare fair model values using assumed credit spreads and assumed volatilities; (2) compare implied volatilities using assumed credit spreads; and (3) compare implied credit spreads using assumed volatilities. We favor method 3 because we believe that forward volatility assumptions are inherently less subjective and easier to maintain than credit-spread assumptions (and for short-dated convertibles, they are even market-observable). We disfavor methods 1 and 2 because we believe that trader-maintained credit spread assumptions are highly subjective and, more importantly, also likely to contain estimates of the alternative beta compensation (e.g., the illiquidity premium) that we are attempting to isolate in our analysis. 28 For example, if the 3 year-5 year spread in HY CDX is 200 basis points, and the expected lives of our two portfolios differed by 1 year (and are within the 3-5 year band), we would add 100 basis points to the implied spread of the shorter-dated portfolio in order to transform it to an implied spread that is comparable to that of the longer-dated portfolio. 29 These cohorts both contain on the order of 800-900 individual bond issues, respectively. As an example, if the BB cohort (average quality 12 in our coding) traded 300 basis points tighter than the B cohort (average quality 15 in our coding), and if the credit quality of our portfolios differed by 1.0 ranks, then we would subtract 100 basis points from the implied spread of the lower-quality portfolio in order to transform it to an implied spread that is comparable to that of the higher-quality portfolio.

23 Applying this methodology, the normalized excess spread of the Hedge Fund Portfolio relative to the Out- right Portfolio is 117 basis points. This is the same as the absolute spread level, reflecting equal and offsetting adjustments for term and credit quality. We offer this normalized excess spread as the market price for certain risks, such as illiquidity risk, that are present in the Hedge Fund Portfolio.30

There are two points worth noting with respect to the credit-quality transformation:

• It is likely that the spread between the BB and B cohorts already contains some information on the market price for illiquidity risk (because B-rated bonds are less liquid than BB-rated bonds). Thus, changes in the normalized excess spread, such as we are documenting in this paper, could be interpreted as changes in the illiquidity risk premium specific to the U.S. convertibles market (i.e., in addition to any change already reflected in the high-yield market).

• It is also likely that there is some convexity in the spread change as we move from BB to B. In other words, the spread difference between the BB and BB– cohorts is likely smaller than the spread difference between the B+ and B cohorts. Because the transformations we are undertaking occur generally in the vicinity of Ba2 and Ba3 credit quality portfolios (the Moody’s equivalents of BB and BB–), we feel that we are adopting a conservative approach by linearly interpolating between the full BB and B cohort levels. In other words, we believe we are tending to underestimate the actual illiquidity premium via our methodology.

We next turn to the task of removing the overlap from the Hedge Fund and Outright Portfolios. We construct the Unique Hedge Fund Portfolio by removing from the Hedge Fund Portfolio those holdings which, as a percent of its total, are represented in the Outright Portfolio (as a percent of its total). We construct the Unique Outright Portfolio in an analogous manner. The Overlap Portfolio is the set of holdings that is common (as a percent of portfolio totals) to the Hedge Fund and Outright Portfolios.

30 The levels of the variables that we used to calculate normalized excess spreads throughout this paper: the 3-year CDX HY index at 233 on 9/30/2014 and 254 on 12/31/14; 5-year CDX HY at 356 on 9/30/2014 and 356 on 12/31/14; BB Index OAS at 301 on 9/30/2014 and 324 on 12/31/2014 and B Index OAS at 423 on 9/30/2014 and 502 on 12/31/2014.

24 Having created these portfolios, we can recast the earlier market pie chart in the following manner:

HOLDINGS OF U.S. CONVERTIBLES BY VISIBLE PORTFOLIO FIGURE 12

HOLDINGS OF US CONVERTIBLES BY VISIBLE PORTFOLIO

UNIQUE HEDGE FUND PORTFOLIO NOT VISIBLE 11% UNIQUE HEDGE FUND PORTFOLIO 21%

UNIQUE OUTRIGHT PORTFOLIO

UNIQUE OUTRIGHT PORTFOLIO OVERLAP PORTFOLIO OTHER PORTFOLIOS 21% 8% OTHER PORTFOLIOS

NOT VISIBLE

OVERLAP PORTFOLIO 39%

SOURCE: SEC, PINE RIVER CAPITAL

Summary statistics for the Unique Portfolios are below:

FIGURE 13 UNIQUE HEDGE FUND UNIQUE OUTRIGHT PORTFOLIO PORTFOLIO

PRICE 153 112 PARITY 134 81 COUPON 2.9% 4.0% PARITY YIELD 0.4% 1.1% RHO (1.0) (4.4) EXPECTED LIFE 2.3 4.9 CREDIT QUALITY 14.0 11.7 UNRATED PORTION 56% 11% OAS 603 348 SOURCE: SEC, BARCLAYS CAPITAL, PINE RIVER CAPITAL

The normalized excess spread of the Unique Hedge Fund Portfolio over the Unique Outright Portfolio is 251 basis points, which is 28 basis points wider quarter-over-quarter.

25 CONCENTRATED HOLDINGS

The histogram of top five holder concentration is below.

HOLDING CONCENTRATION HISTOGRAM: TOP FIVE HOLDERS FIGURE 14 HOLDING CONCENTRATION HISTOGRAM: TOP FIVE HOLDERS 50 22% 42 43 40 36 18% 30 13% % OF USD 23 17 17 16 ALL (BN) 20 9% 8 MV 10 5 3 5 4% 1 - - 0 0%

PERCENTPERCENT OF OF ISSUE ISSUE OWNED OWNED BY BY ITS ITS TOP TOP FIVE FIVE REPORTED REPORTED HOLDERS HOLDERS

SOURCE: SEC, PINE RIVER CAPITAL

Average monthly trading volume (TRACE) for the entire U.S. convertible market is on the order of $15 billion face amount (in an unstressed market)31, compared with a total market size of $186 billion face amount. This means that roughly 4% to 5% of the market turns over on a monthly basis.32 According to Greenwich Associates, market participants have perceived a decrease in liquidity year over year in each of the past four years (with the decrease felt between 2011 and 2012 being particularly acute).33 Looking at these pic- tures together (chunky holding concentrations and decreased liquidity), it is not difficult to conclude that any broad liquidity demand by the dominant holders of convertibles (outright investors) is likely to cause dramatic price concessions.

TOP 5 REPORTED HOLDER CONCENTRATION FIGURE 15 > 0% > 10% > 20% > 30% > 40% > 50% > 60% > 70% > 80% > 90%

ISSUE COUNT 506 490 444 399 344 270 181 107 59 31 TOTAL MV (USD MM) 208,652 203,921 186,921 170,863 132,654 97,916 55,049 30,919 15,579 9,315

PRICE 119 119 120 123 122 126 125 125 129 125 PARITY 96 95 96 99 97 99 99 93 90 77 COUPON 3.3% 3.3% 3.4% 3.5% 3.8% 3.8% 3.8% 3.7% 4.2% 5.1% PARITY YIELD 0.8% 0.8% 0.8% 0.8% 0.9% 0.9% 1.1% 1.1% 1.0% 1.0% RHO (2.3) (2.3) (2.3) (2.4) (2.5) (2.9) (2.3) (3.1) (4.5) (6.7) EXPECTED LIFE 3.4 3.4 3.4 3.4 3.4 3.6 3.2 3.8 4.6 6.2 CREDIT QUALITY 12.3 12.3 12.2 12.2 12.1 11.9 13.2 13.2 13.1 13.0 UNRATED PORTION 31% 30% 28% 26% 26% 21% 26% 17% 14% 7% OAS 425 420 408 409 390 376 395 370 352 351 SOURCE: SEC, PINE RIVER CAPITAL

31 Source: Barclays 32 A security generally needs to trade twice to turn over, once from the seller to the dealer intermediary, and once from the dealer intermediary to the seller. 33 In the 2014 Greenwich survey, 39% of respondents felt that convertible liquidity had decreased year-over-year, versus 12% perceiving an increase (the remaining 49% did not perceive a material change). In 2013, the numbers were 44% and 17%, decreases over increases (39% unchanged). In 2012, 75% of respondents felt that liquidity had decreased (versus only 4% claiming an increase, and 21% unchanged), and in 2011, 39% of respondents claimed decreased liquidity.

26 The previous chart (Figure 15) presents the same summary valuation statistics we presented in our prior analysis, only this time for issue cohorts with various, increasing levels of top 5 reported holder concentration. Some trends emerge as we move from left to right (i.e., from less to more concentrated) on the chart:

• Credit quality erodes at extreme holder concentrations, even as implied OAS tightens (Fig- ure 16);

CREDIT STATISTICS: COHORTS BY TOP 5 HOLDER CONCENTRATION FIGURE 16 CREDIT STATISTICS: COHORTS BY TOP 5 HOLDER CONCENTRATION CREDIT QUALITY IMPLIED OAS 13.5 500

13.0 400 12.5 CREDIT 300 IMPLIED QUALITY 12.0 OAS 200 (BPS) 11.5

11.0 100

10.5 0 > 0% > 10% > 20% > 30% > 40% > 50% > 60% > 70% > 80% > 90% SOURCE: BLOOMBERG, BARCLAYS, PINE RIVER CAPITAL

• Rho and expected life increase, highlighting the potential for price volatility (especially as a result of yield curve steepening);

• Ratings and current yield appear to be drivers of concentration.

INDEXING

The next chart (Figure 17) expresses, over time:

• The change in the market value of the Focus Index; and

• The assets under management growth of a sample set of 17 open-ended dollar-denominated convertible mutual funds and ETFs.34

34 We assembled our list by searching Bloomberg fund listings for the terms “Convertible Fund” and “Convertible Securities.” We removed hedge funds, closed-end funds, non-active, non-US and non-convertible funds from the initial screen, and the final list had these 17 funds: AllianzGI Con- vertible Fund, Ascendant Deep Value Convertibles Fund, Calamos Convertible Fund, Columbia Funds Series Trust - Columbia Convertible Securities Fund, Fidelity Advisor Convertible Securities Fund, Franklin Convertible Securities Fund, Harbor Convertible Securities Fund, Invesco Convertible Securities Fund, Lord Abbett Convertible Fund, MainStay Convertible Fund, Miller Convertible Bond Fund, Palmer Square SSI Alternative Income Fund, PIMCO Convertible Fund, Putnam Convertible Securities Fund, SPDR Barclays Convertible Securities ETF, Vanguard Convertible Securities Fund, Victory Investment Grade Convertible Fund.

27 GROWTH: FOCUS INDEX VS. MUTUAL FUND & ETF FUND FLOWS FIGURE 17 GROWTH: FOCUS INDEX VS. MUTUAL FUND & ETF ASSETS FOCUS INDEX GROWTH MUTUAL FUND & ETF GROWTH 80%

60%

40%

20%

-20%

SOURCE: THOMSON REUTERS, BLOOMBERG, BARCLAYS, PINE RIVER CAPITAL

The chart below (Figure 18) depicts the ratio of assets invested in these 17 mutual funds and ETFs to the total market value of the Focus Index.

MUTUALMUTUAL FUND FUND & & ETFETF ASSETS (AS (AS % % OF OF FOCUS FOCUS INDEX INDEX MV) MV) FIGURE 18

70% 60% 50% 40% 30% 20% 10% 0%

SOURCE: THOMSON REUTERS, BLOOMBERG, BARCLAYS, PINE RIVER CAPITAL

Next (Figures 19 and 20) are time series of weighted average price and weighted average parity for the Focus Index and the rest of the U.S. convertible market.

28 WEIGHTED AVERAGE PRICE: FOCUS INDEX VS. REST OF MARKET FIGURE 19 WEIGHTED AVERAGE PRICE: FOCUS INDEX VS. REST OF MARKET FOCUS INDEX WAP (% OF PAR) REST OF MARKET WAP (% OF PAR) 150%

140%

130% % OF PAR 120%

110%

100%

SOURCE: THOMSON REUTERS, BARCLAYS, PINE RIVER CAPITAL

WEIGHTED AVERAGE PARITY: FOCUS INDEX VS. REST OF MARKET FIGURE 20 WEIGHTED AVERAGE PARITY: FOCUS INDEX VS. REST OF MARKET FOCUS INDEX WA PARITY (% OF PAR) REST OF MARKET WA PARITY (% OF PAR) 120%

110%

100% % OF PAR 90%

80%

70%

SOURCE: THOMSON REUTERS, BARCLAYS, PINE RIVER CAPITAL

The divergence of the balanced universe (as represented by the Focus Index) from the rest of the convertibles market is evident. Two years ago, the broader market and the Focus Index had similar parity and price. But today, the average Focus Index constituent has parity and price points around 19% and 17% of par lower, respectively, than the rest of the market.

29 Below (Figure 21) is the credit-quality time series for the Focus Index:

CREDIT QUALITY: FOCUS INDEX VS. REST OF MARKET FIGURE 21 CREDIT QUALITY: FOCUS INDEX VS. REST OF MARKET FOCUS INDEX CREDIT QUALITY REST OF MARKET CREDIT QUALITY 14

12 CREDIT QUALITY 11

SOURCE: THOMSON REUTERS, BLOOMBERG, PINE RIVER CAPITAL

The Focus Index currently has an equal share of unrated securities to the rest of the market (29%). Accord- ingly, a more punitive ratings treatment of unrated issuers (see earlier discussion) would not change the credit quality of the Focus Index relative to the rest of the market.

The point premium on the Focus Index is not much higher than the rest of the market (26 bond points, versus 23 bond points). However, the Index also pays a far smaller coupon on average to help earn down that premium in the absence of equity volatility.35

WEIGHTED AVERAGE COUPON: FOCUS INDEX VS. REST OF MARKET FIGURE 22 WEIGHTED AVERAGE COUPON: FOCUS INDEX VS. REST OF MARKET FOCUS INDEX WA COUPON REST OF MARKET WA COUPON 5

SOURCE: THOMSON REUTERS, BLOOMBERG, PINE RIVER CAPITAL

35 Parity yield on the Focus Index is 0.7%, versus 0.8% for the rest of the market.

30 The Focus Index would take five-and-a-half times as long as the rest of the market (38 years vs. 7 years) to pay down its premium with excess cash flow (over the underlying common equity). This ratio ballooned in 2014 (Figure 23).

PAYDOWN PERIOD: FOCUS INDEX VS. REST OF MARKET FIGURE 23 PAYDOWN PERIOD: FOCUS INDEX VS. REST OF MARKET FOCUS INDEX PAYDOWN PERIOD REST OF MARKET PAYDOWN PERIOD 40

YEARS 20

SOURCE: THOMSON REUTERS, BLOOMBERG, PINE RIVER CAPITAL

Several factors could help to justify this differential. The most obvious is credit quality (dealt with above). Term differences could also play a role. A longer expected life would tend to offer more time for premium paydown or upside volatility.36 However, the expected lives of the Focus Index and the rest of the market have remained relatively stable over the last few years (Figure 24).

EXPECTED LIFE: FOCUS INDEX VS. REST OF MARKET FIGURE 24 EXPECTED LIFE: FOCUS INDEX VS. REST OF MARKET FOCUS INDEX EXPECTED LIFE REST OF MARKET EXPECTED LIFE 5

3 YEARS 2

SOURCE: THOMSON REUTERS, BLOOMBERG, PINE RIVER CAPITAL

A third factor that certainly matters is the price difference between the two portfolios. A portfolio that is way above par (say, parity of 200) should come very close to paying down its premium over its expected life, because the equity options are so deep in the money that any other outcome than eventual conversion

36 On the other hand, it would also make the bond floor more slippery, so it is actually unclear how this would cut on balance.

31 is highly unlikely. So, the fact that the rest of the market trades 17 points higher than the Focus Index should, all else equal, justify some paydown period differential. This differential is nowhere near the size of the actual gap, in our opinion.

A slightly more refined metric than the paydown period is the “paydown ratio.” A convertible’s paydown ratio is its paydown period divided by its expected life (i.e., how many times longer it would have to live than expected in order for it to pay down its premium with excess cash flow). A paydown ratio of 1.0 would be extremely cheap (except at parity extremes), since the excess cash flows would be expected to completely pay down premium, and holders thus would be getting a senior claim advantage (as well as, possibly, a forcing maturity) for free. Generally speaking, the higher a convertible’s paydown ratio, the greater must be its promise of convexity to the downside. Conversely, the lower its paydown ratio, the closer it is to a theoretical arbitrage-free price bound.

Arbitrage-free price bounds can be very important barriers. They can serve as momentum arresters in the case of market free-fall, because they represent price points near which arbitrageurs should step in to support the market. Below (Figure 25) we present the paydown ratio time series for the Focus Index and the rest of the market.

PAYDOWN RATIO: FOCUS INDEX VS. REST OF MARKET FIGURE 25 PAYDOWN RATIO: FOCUS INDEX VS. REST OF MARKET FOCUS INDEX PAYDOWN RATIO REST OF MARKET PAYDOWN RATIO 12

8 PAYDOWN RATIO 6 4

SOURCE: THOMSON REUTERS, BLOOMBERG, PINE RIVER CAPITAL

This time series speaks for itself. Focus Index securities are nowhere near levels where convertible hedge funds might begin to care as an arbitrage. It appears, then, that the price stability of the Focus Index is purely a function of the persistence of the current supply/demand imbalance. Although it represents just 17.5% of the market’s value, the Focus Index drags all of the aggregate market metrics up commensurately, rendering the hedge-fund investable market (i.e., non-Focus Index convertibles) cheaper than one might expect on the basis of broad market perception.

Hedge Fund Managers hold less of the Focus Index than they do of the rest of the market (see Figure 26 on the next page).

32 HOLDINGS OF U.S. CONVERTIBLES BY INSTITUTION TYPE FIGURE 26 HOLDINGS OF US CONVERTIBLES BY INSTITUTION TYPE FOCUS INDEX NON-FOCUS INDEX ALL CONVERTIBLES

60% 54% 50% 47% 48% 40% 29% 30% 26% 20% 16% 10% 0% HEDGE FUND MANAGERS INVESTMENT ADVISORS

SOURCE: SEC, THOMSON REUTERS, BLOOMBERG, PINE RIVER CAPITAL

This relationship is actually not quite as stark as we might have expected, based on Focus Index valuation (discussed below). Some degree of “front running” activity may be at play.

Below we present summary statistics for the Focus Index and the rest of the market. In an attempt to assess the persistency of any index inclusion effect, we also present summary statistics for the portions of the market that were in the Focus Index at some point in the last two years but have now been removed, and those that were never in the Focus Index over the last two years.

FIGURE 27 REMOVED FROM NEVER IN FOCUS INDEX FOCUS INDEX FOCUS INDEX REST OF MARKET (2013-2014) (2013-14)

ISSUE COUNT 45 473 33 440 TOTAL MV (USD MM) 38,455 182,350 34,642 147,707

PRICE 105 122 152 116 PARITY 80 99 137 92 COUPON 1.3% 3.9% 2.3% 4.2% PARITY YIELD 0.7% 0.8% 0.6% 0.8% RHO (2.3) (2.3) (1.6) (2.4) EXPECTED LIFE 3.8 3.3 3.0 3.4 CREDIT QUALITY 12.4 12.3 10.1 12.6 UNRATED PORTION 29% 29% 18% 30% OAS 252 457 497 451 SOURCE: THOMSON REUTERS, BLOOMBERG, PINE RIVER CAPITAL

The key statistic here is the OAS discrepancy between the Focus Index and the rest of the market (252 versus 457). As noted earlier, the credit quality differential actually runs in favor of the rest of the market at this point. We believe this provides significant evidence of indexing behavior that will likely impact the returns of Focus Index investors at some point.

The Focus Index trades at a normalized excess spread of –242 basis points to the rest of the market, out from –188 basis points one quarter earlier. The effect does not appear persistent, as the Removed from Fo- cus Index cohort actually trades at a wider spread than the Never in Focus Index cohort.

33 THANK YOU FOR YOUR CONTINUED SUPPORT AND INTEREST IN PINE RIVER.

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