THE CAPITAL STRUCTURE ARBITRAGE REPORT

Description of Research
The Capital Structure Arbitrage Report identifies securities, predominantly debt securities, that exhibit an asymmetrically favorable risk/return profile: those that will provide a high return in the positive case, but with limited or well-defined limit of loss in the negative case. Generally, the abridgement of risk is achieved through an arbitrage or hedge transaction with a second or even third security, typically within the capital structure of the same company. The limited-risk properties of such trades make many of them particularly suitable to the use of leverage.

The description of a trade with multiple securities will include a sample hedge ratio as well as a set of scenario analyses. These generally include an expected base return, as under a condition of static prices; the return in a success scenario; and the expected return or breakeven point under a failure scenario. It will also include a valuation of the issuer to the degree that the trade is dependent upon a security’s over- or under valuation and subsequent correction.

This type of pricing anomaly often arises due to the institutional constraints of various investors, as when securities are in transition between constituencies. Examples would include convertible bonds whose change in pricing no longer qualifies them as equity substitutes and are becoming bond substitutes; investment grade bonds that have become non-investment grade; equity-related obligations within a given capital structure that are accorded premium valuations relative to the pure debt of the same issuer. The population of such asymmetric return securities is generally quite limited and new trades are not always readily available. Therefore, any number of subsets of this universe is employed if they offer the requisite risk/reward profile. These might include, but are not limited to:

Description of Service
Convertible Arbitrage: This subset is of convertible stocks or bonds whose terms and prices allow for an arbitrage versus the underlying equity, such as when the equity is overvalued, with the goal of profiting from a collapse in the share price. In this instance, the analysis will include a strategic assessment of the issuer as well as a fundamental valuation of the securities.

Intra-capitalization Hedged Investing: This subset would include convertible securities or even straight debt whose risk can be hedged in an effective manner. The hedge mechanism might be the short-sale of the issuer’s common shares or the purchase of options or other related securities in a manner that provides a pre-defined breakeven point (under a failure scenario) that is meaningfully lower than for the unhedged investment.

Intra-capitalization Credit Spread Arbitrage: This approach capitalizes on mutually mis-priced securities within a company’s capital structure, such as when an obligation of lower credit standing trades at the same (or too similar) yield to a more senior obligation. When priced advantageously, a long position in the senior security can be arbitraged against a short position in the junior security such that minimal credit risk is assumed while awaiting the reversion to a normalized yield spread.

Intra-capitalization Time Spread (Convergence) Arbitrage: Occasionally, a near-term maturity is seen as being of lesser risk than a longer-term security of identical credit standing of the same issuer, typically when the issuer is facing impending financial illiquidity. The resultant pricing and yield discrepancies between the two securities, which should ultimately converge, lend themselves to appropriately structured arbitrage trades.

Inter-company Credit Spread Arbitrage: There are circumstances in which the failure (or success) of one company or security must be preceded by (or might be conditional upon) the failure or success of another company that is more sensitive to the same critical variable. This can allow for arbitrage or hedged trades that are long the security of the stronger and short the security of the more vulnerable company.

The fundamental risk of investing in equity securities is the risk that the value of the stock might decrease. Stock values fluctuate in response to the activities of an individual company or in response to general market and/or economic conditions. The market value of all securities is based upon the market's perception of value and not necessarily the book value of an issuer or other objective measures of a company's worth.

The financial condition of an issuer of a debt security may cause it to default or become unable to pay interest or principal due on the security. If an issuer defaults, the affected security could lose all of its value, be renegotiated at a lower interest rate or principal amount, or become illiquid. Securities rated below investment grade generally have greater credit risk than higher-rated securities. Companies issuing high yield, fixed-income securities are less financially strong, are more likely to encounter financial difficulties and are more vulnerable to changes in the economy than those companies with higher credit ratings.

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