Convertible Arbitrage Strategy

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Convertible Arbitrage Strategy
New York 1065 Avenue of the Americas, 31st
Floor, New York, NY 10018 1 212 482 1600
London 42 Brook Street, London W1K 5DB UK
44 203 008 8266
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Introduction
Advent Overview

• Advent Capital Management, LLC was founded in
  1995 and specializes in convertible, high yield,
  and event-driven strategies based on a credit
  focused investment process.
• Our investment team consists of 22 seasoned
  professionals with significant investment
  experience.
• Two members of Advents investment team were
  named All Stars by Institutional Investor
  magazine.
• Advent has 49 employees performing portfolio
  management, research, trading, client services
  and marketing.
• Advent manages approximately 4.3 billion1 in
  hedge fund, long-only and closed-end

1. As of August 31, 2007.
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Convertible Education
Definition of a Convertible

• A convertible security is a corporate bond or
  preferred stock with an embedded option that
  allows the holder to convert the bond or
  preferred stock into a fixed number of common
  shares of the issuing company.
• Like other corporate bonds and preferred stocks,
  convertible securities pay a fixed rate and
  convertible bonds have a maturity date.
• Convertibles have the added feature of allowing
  the holder to convert the security into common
  stock.

Common Stock
Embedded Option


Bond or Preferred
Convertible Security
Investor Choice
Corporate Bond
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Convertible Education
Convertibles Derive Value From Two Sources
Embedded Option
Bond or Preferred

• Bond Value
• Coupon
• Maturity
• Call Protection
• Puts
• Cost of Debt (rate spread)

• Equity Value
• Conversion Value
• Volatility
• Call Protection
• Stock Dividend
• Interest Rates

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Convertible Education
Convertible Price Dynamics
Equity Investors Convert Arb Funds
Distressed Investors
Fixed Income Investors
Convertible Funds
Convertible Price
Convertible Bond Price
Conversion Premium
Bond Value
Stock Price
In the Money
Distressed
Busted/Out of the Money
Traditional Convertible
Underlying Common Stock Price
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Convertible Education
An Issuer Viewpoint

• Less dilutive than common stock offering.
• Issuer saves on coupon by monetizing corporate
  asset that is freevolatility.
• Less costly than pure debt offering and potential
  conversion to common by holders if equity
  performs gt no principal repayment.
• Cost effective financing for high growth
  companies/markets.
• Expand investor baseflexibility, less
  restrictive covenants.
• Exchangeable structure allows for monetizing a
  stake in another company defers capital gains
  until maturity
• Recent innovation provide tax and EPS advantages.

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Convertible Education
Diverse Investor Base

• Dedicated Convertible Funds
• Part of Big Mutual Funds
• Growth and Income or Total Return Funds
• Used as defensive investments in common stocks
  to reduce volatility and for current income
• Pension Funds and Insurance Companies
• Exposure to common stock while receiving current
  income
• High Yield Funds
• Busted convertibles where the stock option is
  deep out of the money and the convertible is
  trading like straight debt
• Hedge Funds
• Employ various arbitrage strategies involving
  debt, equity and options components
• Distressed Funds

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Convertible Market Overview
Current Convertible Market Trends

• The convertible market has grown to 661 billion
  globally and 334 billion in the US through
  August, up from 50 billion in the US in 1989.
• Global new issuance of convertible securities has
  dramatically increased through August 2007 with
  534 new issues totaling 138.3 billion (69.5
  billion in the US)making issuance on pace to be
  the best year ever.
• Liquidity and diversification have increased
  substantially with the growth of the market.
• Key drivers that make the current convertible
  market attractive
• More coupon paying convertibles in place of
  volatility-dependent new issues with
  small/baby coupons and higher conversion
  premiums.
• Shorter maturities from 25-30 years to 4-10 years
  on average.
• Extended call protection up to 5-10 years in many
  cases from 2-3 years.
• Increased volatility makes convertibles more
  valuable.
• Positive long-term investment opportunities and
  total return potential seem unusually attractive
  at present and it began with the sell-off in 2005
  from convertible arbitrageurs.
• An increasing number of convertibles include
  ratchets that provide greater protection from
  cash takeovers and LBOs than is typical of
  nonconvertible fixed income securities.

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Convertible Market Overview
Market Size Global Convertible Market Has Grown
Dramatically
( in Billions)
Convertible new issuance should continue to be
robust as companies look for alternative sources
of financing.
Source UBS Convertible Research
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Convertible Market Overview
Volatility Suggests an Opportunity Increased
Volatility is Positive for Convertible
Securities As of August 31, 2007
Higher stock volatility increases the value of
the embedded equity option which makes the
convertible more valuable.
As measured by the VIX.
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Convertible Arbitrage
A strategy that employs volatility and credit
understanding to generate absolute returns
irrespective of market movement
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Convertible Arbitrage Strategy

• Convertible Arbitrage consists of
• Purchasing a convertible security which provides
  a higher yield than equity.
• Selling short the underlying stock.
• The combined positions create a market neutral
  profile by hedging out the equity exposure
  imbedded in the convertible.
• Returns are generated from
• Enhanced Income from the Arbitrage Position
• Current Yieldcoupon or dividend on the
  convertible security
• Short Interest Rateinterest on proceeds from
  short sale of stock
• Net Capital Gains
• Trading profits are realized as individual hedge
  positions are adjusted to reflect price movements
  in the convertibles and the underlying stocks.
• Due to mispricing of the bond and option value,
  profits can be generated as issues approach fair
  market value.

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Convertible Arbitrage Strategy
Ford Trade Example4.25 Convertible Bonds due
December 15, 2036
Static ROE 8.3
Long ROE 5.8
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Convertible Arbitrage Strategy
Generating Absolute Returns with
ConvertiblesBetter profiles for absolute returns
than in last decade.
1986
1996
2002
2005
2009?
Volatility Driven
Positive Asymmetry
Cash Carry
Credit Driven

• Large coupons
• High short rebates
• Interest rates coming down from 21

• Pick-up of global equity volatility
• VIX rises from 12 ? 40
• Emergence of pure volatility strategies

• Duration of market substantially shortened (6.7
  years)
• Limited downside
• Positive yields to short maturity
• Substantial delta/gamma profiles

• Credit spreads tighten from historic highs
• CCC tighten from 1500 to 450

Convertibles have dual optionality on equities
and volatility.
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Convertible Arbitrage Strategy
Strategy Objectives

• Generate absolute returns by applying a
  multi-strategy based approach to convertible
  arbitrage.
• Take advantage of market inefficiencies and the
  complexities of convertible securities (i.e.
  puts, calls, ratchet features) to generate alpha,
  based on technical and fundamental analysis of
  attractive opportunities.

Volatility Market Neutral Asymmetric Return/Risk
Profile Capture Trading Profits When Vol
Rises Automated/Disciplined Gamma Trading Profits
Income Convertibles Within 20 Of Their Bond
Floor Asymmetric Returns - Low Downside Risk,
High Gamma No Need For Market Neutral Hedge
International Asia, Japan, Europe And Emerging
Markets Under - Researched Convertibles Increasing
Primary New Issues
Short Short The Convertible With A Long Stock
Hedge Capture Declining Volatility Hedge For Part
Of The Book Better Carry
Event-Driven Earnings, Takeovers, Geopolitical,
Economic Special Features In Bond
Indentures Asset Swaps
Options Overlay Collect Option Premiums By
Selling Option Strategies Against Long
Convertible Positions Increases Income Return And
Offsets Long Vega Exposure And Reduces Theta Costs
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Conclusion

• Convertible Arbitrage Provides
• Absolute Returns
• Convertible arbitrage has historically provided
  higher returns than most major stock and bond
  market indices on both an absolute and
  risk-adjusted basis.
• Low Correlation to Stocks and Bonds
• An allocation to convertible arbitrage
  diversifies an overall portfolio.
• Low Volatility
• The volatility of returns from convertible
  arbitrage has been lower than the volatility of
  the Lehman Brothers Aggregate index due to market
  neutral dynamics of hedge.