cover, macro & strategy overview 2015 1q screenshow · 2019-12-05 · investcorp macroeconomic...

INVESTCORP

INVESTCORP HEDGE FUNDS ENVIRONMENT REPORT

FIRST QUARTER 2015

Lionel Erdely

Head and Chief Investment

Officer of Hedge Funds

Rebecca Hellerstein

Cross-Asset Strategist and

Head of Cross-Asset

Investments

Jonathan Feeney

Head of Macro and

Relative Value Strategies

Elena Ranguelova

Head of Credit and

Equity Strategies

Sunil Nair

Head of Risk

and Research

INVESTCORP Investcorp Hedge Funds Environment Report | 1st Quarter 2015

Table of Contents

Page

Section 1: Macroeconomic and Hedge Fund Strategy Outlook 1

Section 2: Global Macro 15

Section 3: Hedge Equities 33

Section 4: Credit 39

Section 5: Event Driven 51

Section 6: Convertible Arbitrage 55

Section 7: Fixed Income Relative Value 59

INVESTCORP Macroeconomic and Hedge Fund Strategy Outlook | 1st Quarter 2015

Ten Themes for 2015

We lay out here our views on the top

macroeconomic themes for 2015 and how they

will play out in markets.

1 Global growth accelerates,

inflation decelerates.

We expect global growth to accelerate above trend

in 2015 led by an increasingly dynamic US economy,

while global inflation decelerates with the fall in oil

prices. This type of macro environment is generally a

sweet spot for risk assets with decent mean returns

and Sharpe ratios across both traditional and

alternative asset classes.

The unusual though not historically unprecedented

divergence in growth outlooks across developed

markets (DMs) in 2014 contributed to market

volatility over the year. By contrast, 2015 should see

a slow convergence in growth rates to the US’s lead

while inflation bottoms in the second half of the

year. Growth in the Euro area and Japan should

gradually pick up over the year as the tailwind

from monetary stimulus and lower oil prices

supports demand.

2 DMs’ monetary policies diverge

In 2014, the Fed embarked on its multi-year plan

to normalize policy. First, it ended QE purchases

and revised its forward guidance at the last FOMC

meetings of the year. Next, it should start to raise

the federal funds rate target by the middle of

2015 as the US labor market continues to heal and

wages firm. Meanwhile, the BoJ and ECB are

gearing up to provide further monetary stimulus

in the first half of 2015. We expect this divergence

to generate uncertainty amongst market

participants and modest dislocations across global

bond markets in the first half of the year.

3 Bond conundrum: The sequel

As the Fed embarks on a historically

unprecedented tightening cycle, the demand for

US Treasuries will continue to outstrip supply by a

substantial margin. Growing demand by G4

central banks will encounter a shrinking supply of

Govies, leading to excess demand of roughly

$400bn relative to a market size of $2tn. As a

result, the long end of the Treasury curve should

appear quite similar to that of the bond

conundrum period from 2003-2006. During this

period, yields at the long end of the curve

declined even as the FOMC hiked the federal

funds rate multiple times.

4 OPEC tests frackers

Over the first half of 2015, oil prices will continue

to overshoot on the downside as OPEC refrains

from cutting production despite rapidly growing

supply from US and Canadian shale producers.

The remarkable 2014 growth in individual wells’

output suggests that Moore’s Law may apply to

output in the fracking industry in the sense that it

doubles every 18 months.

As this shakeout matures, it should become clear

whether its fundamental driver is innovation

increasing supply (and moving the industry from

an oligopolistic to a competitive equilibrium in

which price equals marginal cost) or OPEC testing

fracking producers to see how many survive an

extended period of lower prices. Thus far, frackers

have proven resilient, moving equipment from

high to low cost locations, but in either scenario

they face a prolonged period of low prices.

5 US wages firm. Will inflation?

As the US labor market continues to outperform

expectations and wages begin to show signs of

firming, the obvious next question is when this

upward pressure will pass-through to prices.

Our view is not until late 2015. Given the

pronounced declines in oil prices since mid-2014,

it is unlikely that the core PCE index (the Fed’s

preferred inflation measure) will accelerate

significantly above its 2% target before 2016. A

decline in oil prices of more than 25% (recent

declines are above 40%) generally has second-

round effects that lower core inflation, albeit by

much less than the first-round effects on headline

inflation. This suggests core inflation will

decelerate through the first half of 2015, flatline

for a few months, and then accelerate modestly

as 2016 approaches.

6 Slow pace of bank deleveraging limits the

Euro area’s growth potential

We do not expect the Euro area’s credit conditions,

which remain its major growth headwind, to

improve substantially over 2015. Principal-agent

STRICTLY CONFIDENTIAL | 1


issues in its banks’ typical management practices

make it unlikely that their deleveraging will pick up

from its current tepid pace. Standard practice in

the region is to retain existing management to

oversee the sales of distressed assets. Naturally,

this creates a conflict of interest when current

management originally acquired these assets, as is

generally the case. By slowing the pace of sales,

management avoids the negative reputation

effects from acknowledging much of the balance

sheet’s current distressed valuations. Until these

management practices change, we expect the

region’s banks to pick up the pace of deleveraging

only under pressure from regulators.

7 Muddle-through growth in China

China begins 2015 hobbled by its troubled real

estate sector, the spare capacity in its industrial

sector, and its economy’s excessive dependence on

the leverage provided by shadow banks. Analysts

often draw parallels to the US economy in the

2006-7 period, with its excessive reliance on a

shadow banking system that proceeded to wreak

havoc across financial markets. More likely for

China than this catastrophic outcome, in our

view, is one of modest growth over 2015, as the

economy is redirected from its current unhealthy

reliance on credit to more sustainable sources

of demand.

8 Fragile stage of EM credit cycle

The rapid moves in FX and commodity markets

over the second half of 2014 may serve as the

catalyst to bring the current overextended credit

cycle in EM to an end. Over the past few years,

many EM’s dirty floats to the dollar caused them to

import excessive monetary stimulus from each of

the Fed’s QE programs. At present, the most

vulnerable EM economies combine high external

funding needs and significant dollar exposures.

These include Turkey, South Africa, Indonesia,

Malaysia, and Brazil, of which all but Brazil are net

oil importers. (By contrast, Korea and India win big

from the decline in oil prices.)

As EM corporate bond indexes are dominated by

the energy and financial sectors, we expect a wave

of defaults in EM corporate credit if oil prices

remain below $60 through mid-2015. The expected

flattening of the US yield curve should be an

additional headwind for EM financial institutions as

the substantial capital inflows of the past few years

reverse for the higher carry available in the US.

For EM sovereign debt, defaults are less likely, as

the balance sheets of most sovereigns are in

better shape than in the run-up to the 1998 crisis

because they are issued in local currency. But we

do expect downgrades for countries with

substantial energy exposure and large external

funding needs, most notably in Latin America

(Brazil, Venezuela, Chile, Peru).

9 FX: Momentum pays

We expect the dollar to continue to strengthen

over 2015. Its movements with respect to the yen

and euro should reflect widening rate differentials

from the increasingly divergent monetary policies

of the Fed, the BoJ, and the ECB. Its movements

against EM oil importers should reflect currency

depreciations to address current account deficits or

to stimulate inflation, and against oil exporters to

rebalance demand away from the energy sector.

Technical factors should also play a role in the

dollar’s strength as FX momentum strategies

generally exhibit significant autocorrelation. Their

strong returns for the dollar in 2014 suggest they

should continue to perform well at least through

the first half of 2015.

10 Liquidity-driven bouts of volatility

The availability of liquidity has fallen in a number of

markets with the shrinkage of broker-dealer

inventories to comply with Dodd-Frank prop

trading requirements. These structurally lower

inventories act as an amplification mechanism

turning small shocks into sustained market

dislocations. As a result, we expect more

protracted periods of volatility over 2015 than over

the past few years.



Hedge Fund strategy outlook

Strategy

Change from

previous quarter Negative Neutral Positive

Hedged Equities ��

Special Situations / Event ��

Macro + ��

Corporate Credit ��

Equity Market Neutral ��

CTA + ��

Structured Credit – ��

FI Relative Value ��

Convertible Arb ��

Corporate Distressed ��

Investcorp’s investment strategy is driven by our in-house proprietary hedge fund research effort. This

research studies the drivers of individual hedge fund strategies and measures their attractiveness through a

variety of indicators, which are highlighted in the following pages.



Hedge Fund strategy outlook

We maintain a “Positive” rating on Hedge Equities

and see an expansion in the opportunity space for

long-short equity managers.US is the region with

the most macro momentum with larger

opportunities away from the large caps. Loose ECB

monetary policy & Euro depreciation should

support profit growth in the Eurozone with

downside risks from deflationary dynamics in the

periphery and a broken credit system. Japan should

benefit from delay in consumption tax increase,

currency weakness and US growth as should Asia

Pacific from the global manufacturing cycle. Europe

should particularly benefit from the recent sell-off

making stocks attractive from a technical

perspective. The risk premiums in developed

economies are close to lows last seen in the middle

of the last decade (but higher than during the

dotcom bubble in late 90s) but current valuation

can be supported by improving earnings

expectations and in the case of S&P a marked

change in composition of the index towards more

financials and technology firms that have higher

growth prospects. There is also a wide dispersion in

equity premiums across markets with Asia

(especially China) offering good value. Our

expected return models are very positive on Japan

and Europe.

We have a “Positive” rating on Special Situations /

Event Driven strategies predicated on strong

corporate balance sheets in the US that are flush

with cash in excess of $2.0 trillion. Corporate profit

for companies in the S&P is 9.6% and return on

equity around 14.6%. We believe that shareholder

pressure (or activism) will lead to a sustained

increase in event-driven activities including

buybacks, mergers and recapitalizations. 2013 was

a very strong year for investor activism with 336

instances (up from 243 in 2012), and was 256 in

first three quarters of 2014. We continue to be

positive about opportunities in investing in special

situations with the risk to the downside from

increased volatility in the equity & credit markets.

We are “Positive” on Macro. We believe that the

macro opportunity set will richen as we see an

increase in policy divergences across the globe

manifest itself in reduced asset correlations and the

formation of some price trends. We continue to

see less opportunities for pure fixed income macro

specialists in spite of the near term volatility that

we observed in October; we do, however, see

opportunities for emerging markets specialists as

the withdrawal of quantitative easing by the

Federal Reserve is expected to have a

disproportionate impact on leveraged emerging

market balance sheets. Broadly, we believe that

managers with the ability to play sovereign credit

should have a rich opportunity set. The modest

increase in cross asset correlations we saw in Q1

2014 has dissipated and we see a continuation of

the secular decline in cross asset correlations.

We remain “Modestly Positive” on Corporate

Credit, as valuations fully reflect the low default-

rate environment and strong corporate balance

sheets in the US. The rise in spreads in High Yield

does provide expected returns higher than a few

quarters back and the strength of the corporate

balance sheet supports the thesis of a slow grinding

down of spreads. The dispersion across corporate

credit has increased significantly and provides great

opportunity for long short credit managers.

We are “Modestly Positive” on EMN even as we

continue to see commoditized factor models

delivering sub-optimal alphas in the developed

markets. However, returns to non-market factors

are attractive in other parts of the world, especially

the Asia-Pacific region. We favor managers who are

globally diversified and who can successfully time

their factor exposures. We continue to have a “wait

and watch” approach to statistical arbitrage

managers since realized volatility in equity markets

has ground lower except for brief spikes making it

difficult for programs to earn alpha harvesting

volatility over their transaction cost.

We have upgraded our ranking to “Modestly

Positive” on CTAs. We see emergence of trends in

certain asset markets like foreign exchange that

bodes well for trend following models. Recent

structural suppression of volatility, particularly in

fixed income markets due to quantitative easing,

combined with potential long-term reversals of

fixed income markets have hampered quantitative

trend-following models in the fixed income space

and reversal of rates is a risk to the strategy. With a

modest increase in volatility expected in the

coming quarters, we continue to prize CTAs’

abilityto diversify risks and provide downside



protection if the markets were to face any

turbulence.

We now have a “Neutral” rating on Structured

Credit as a strategy. We expect Europe to

outperform the US on the back of the proposed

purchases of Asset backed paper by European

Central Bank, but are in general concerned about

the liquidity induced volatility in the structured

credit markets. Structured credit has benefited

from a one way flow of long term money into the

asset class over the last four years which will

reverse leading to mark downs. We have

anecdotally seen fairly wide bid ask spreads on

everything but the largest issues traded in size.

Our “Neutral” rating on Fixed Income Relative

Value is unchanged. We structurally like Relative

Value strategies as hedge funds step into the void

left behind by the exit of bank proprietary trading

desks. The structural change in fixed income

markets – with the Federal Reserve as the largest

holder of mortgage backed securities – precludes

the kind of volatility that marked previous

instances when rates were raised. The current

environment provides FIRV managers with limited

opportunities to trade volatility and to profit from

banks reducing dealer inventory.

The “Modestly Negative” rating on Convertible

Arbitrage is also unchanged. Our outlook for

convertible bonds as an equity substitute is neutral

because of the overweight in energy composition

of the convert universe. The valuation dynamics are

not very attractive relative to credit and volatility

markets making us modestly negative on

convertible arbitrage. For arbitrage portfolios,

credit spreads remain tight across all markets and

below the historical average, discounts-to-

theoretical levels are unattractive, and volatility –

both realized and implied – remains at cyclical lows.

We do, however, see some improvements in the

issuance calendar which could provide some extra

return opportunities but not enough to make a

difference.

We maintain a “Modestly Negative” rating on

Corporate Distressed. A low distressed ratio of just

3% in bonds currently provides very little

opportunity to earn outsized systematic risk

premium from this strategy. We do have a more

favorable view on European distressed versus US

distressed basically for reasons of supply from

deleveraging European banks. Higher expected

default rates and the fragmented jurisdictional

presence across the continent create an added

level of complexity, but also a more robust

opportunity set. We also remain cautious about

the increase in issuance of non-US high yield debt

and the deterioration in the quality of the loans

being made. We also expect to see more

opportunities in specific sectors such as energy that

have faced recent volatility in prices; the shakeout

induced by OPEC will create losers whose debt will

need to be restructured and worked out.



Hedge Equities

Driver of

Strategy

Returns Comments

Attractiveness

Score

(Scale 1 to 10)

Valuations

The equity premium is low compared to recent past, but

above the tech bubble from the late 90s. Long term

valuation metrics do not fully capture the change in

composition of indices especially in the US towards more

technology and financial firms that have traditionally

higher earnings growth rates.

8

Earnings

Earnings in the US are healthy with expected positive

growth and generally positive earnings surprises.

Earnings in Europe should benefit from currency

depreciation and our long term view is of earnings

growth in Japan but with a wider band of uncertainty.

8

Momentum /

Sentiment

Short-term momentum has been positive, and sentiment

remains bullish. While this can be seen as a contrarian

indicator we see good reason for the optimism and

central bank actions continue to favor equities.

8

Macro Backdrop

The World GDP forecasts have been upgraded on the

back of strength in the US and the drop in energy prices.

There is some expected divergence in economic

performance especially between energy producers and

energy consumers as well as the developed economies

and emerging markets.

7

Liquidity and

Financing Leverage levels are lower than historical averages and

well within prescribed limits. Liquidity is also not a

significant issue in this strategy.

9

1

We are positive on Hedge Equities for both fundamental and flow-related reasons. Valuations richened in the US, Japan and Europe in 2013, but so far in 2014 the

driver in the US has been improving corporate earnings. We expect to see divergence in returns across markets, which is ideal for global players who can either

allocate across markets or excel at security selection. The trend of rising correlations, which was a negative for the strategy in recent years, has turned with minor

hiccups both across and within markets. This should also make security selection more profitable.

1. Median returns of Investcorp’s strategy peer group. Strategy peer groups are created by Investcorp and are comprised of funds that Investcorp has judged to be relevant for each strategy.

Source: Investcorp, US Federal Reserve

(24)

(18)

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US Hedge Equities Strategy

Average Median Quarterly Return

Average Quarterly Equity Dispersion



Special Situations / Event Driven

Driver of

Strategy

Returns Comments

Attractiveness

Score

(Scale 1 to 10)

Valuations

Valuations for Event Driven and catalyst-

oriented equities remain compelling. Global

mergers have in pockets been driven by tax

driven arbitrage and subject to increased risk

of regulatory overreach.

8

Supply

Low interest rates have been the driver for

corporate activity and we do not see it

changing in the current quarter. There have

been a few high profile deal breaks, but the

norm is for low probability of breakage and

reasonable deal spreads.

8

Capital

Risk capital is available as many Event Funds

have liquidity and are investing in their

respective strategies

9

Liquidity

Strategy does not provide liquidity

to the market. As market liquidity is healthy,

the environment for the strategy should get

better.

8

Financing Not an issue. This strategy typically

does not use significant leverage.

2

We remain positive on Special Situations / Event Driven equity strategies though a notch less than we were previously. This change in view is based on our

observations of slightly higher volatility in markets and a greater probability of deal breakages than is currently priced in. The fundamental driver of our positive

view remains intact with strong corporate balance sheets, low level of corporate investments, large net cash and the opportunity to use financial engineering to

enhance shareholder value.



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Median 12-Month

Rolling Returns1Event Driven Strategy

251421 402 434 406 462

1,059

1,575 1,784 1,687 1,759

1,815

0

500

1,000

1,500

2,000

2,500

2009 2010 2011 2012 2013 2014

Small-Cap ($200M-$1B)

Mid-Cap ($1B-$5B)



Global Macro

Driver of

Strategy

Returns Comments

Attractiveness

Score

(Scale 1 to 10)

Fundamentals

We are increasingly seeing divergence in

fundamentals and not just central bank

easing driving behavior of risk assets. In

addition, we see macro managers taking on

more risk looking to profit from these

opportunities.

7

Trends

Risk assets have trended well in the last year

and a half especially equity & foreign

exchange markets. A number of the macro

managers were wrong footed by market

moves. Gradual tightening of monetary

policy by the Fed should provide a fertile

environment to trade around inflection

points and profit from them. We believe the

opportunities will be in trading emerging

markets and foreign exchange and not fixed

income when policy thrust changes

6

Liquidity

Not an issue. Most managers trade

exchange-traded instruments which have

very high liquidity.

9

Financing


exchange-traded instruments which have no

financing risk. Current financial conditions

are easy

9

3

Our outlook for Global Macro is positive. We have seen early signs that macro managers are now willing to take on more risk as policy uncertainty and the “risk on /

risk off” environment abates, evidenced by wide dispersion among managers with varying investment views. There are trends forming in foreign exchange markets

across developed & emerging markets driven by monetary policy changes in the US, Europe and Japan. The prospect of increased fixed income volatility and

normalizing of yield curves presage further opportunities in fixed income trading, but we see that as a Q2 2015 story.



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Median 12-Month

Rolling Returns 1Global Macro Strategy

Median Returns - Macro Systematic

Median Returns - Macro Discretionary

RecessionRecovery

& GrowthRecession Recovery

Slowdown/

RecessionRecovery



Corporate Credit

Driver of

Strategy

Returns Comments

Attractiveness

Score

(Scale 1 to 10)

Valuations

Corporate yield to worst were at close to the

lowest levels they had been in the last

twenty years, but have come off those lows.

We have seen them widen in the last couple

of quarters and become more volatile that

provides fertile ground for nimble credit

traders.

7

Supply

There has been an unprecedented amount of

issue of high yield credit over the past two

years matched by an increase in demand for

credit from long term investors and ETFs.

Supply of bonds in Europe should be healthy.

5

Capital

Capital is plentiful relative to the opportunity

set in an environment where there is a dash

for yield.

5

Liquidity

Strategy does provide liquidity to the market.

The liquidity in the market is affected by the

ongoing disintermediation and contracting of

dealer balance sheets and ETF flows. We

continue to be worried about the ability of

investor balance sheets to cope with the

liquidity mismatch this creates.

5

Financing Not an issue. This strategy typically does not

use leverage. 6

4

in the US. Emerging market credit is overly exposed to what happens to US interest rates and the surge in issuance. Europe spreads have ground lower but do

provide some opportunity for attractive risk-adjusted returns. We worry about the ability of the market to absorb shocks given limited dealer balance sheet

availability.



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Hig

h Y

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s)

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Bond Yield & Distressed Ratio

Distressed Ratio Bond Yield



Equity Market Neutral

Driver of

Strategy

Returns Comments

Attractiveness

Score

(Scale 1 to 10)

Dispersion

Average correlations between stocks, which

have been high, are now coming off high

levels recently. This implies that investors are

beginning to discriminate between stocks on

a fundamental basis and not macro and

liquidity considerations.

6

Capital

Capital in the strategy has reduced

considerably. Many Hedge Funds and Bank

Proprietary trading desks have exited the

business.

5

Liquidity


exchange-traded instruments which have

very high liquidity.

5

Financing Leverage levels in the strategy have

normalized. 5

5

Our outlook for the EMN strategy is modestly positive. Valuation spreads are slightly above their historical averages; return dispersions are rising and correlations

are declining. These trends suggest normal returns for the strategy going forward. We see strong opportunities outside the core of US, Europe and Japan – i.e., Asia

and developing Europe. Premiums earned for style factors such as size and value are lower than historical averages, indicating either a cyclical trough or the

reduced compensation for these sources of risk. In addition, we see liquidity and flows improving in Europe that benefit both momentum and relative value

strategies. Muted market volatility makes us cautious about allocating to statistical arbitrage managers.



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Median 12-Month

Rolling Returns 1Equity Market Neutral Strategy



Structured Credit

Driver of

Strategy

Returns Comments

Attractiveness

Score

(Scale 1 to 10)

Valuations

Legacy credit trade at a discount to par

which should partially normalize as these

instruments move closer to maturity, but

nearly 10 years from the boom period means

a reduction in opportunities to play the pull

to par.

5

Supply

Legacy supply is still dominant in the market.

However there are also some new issues that

have come to market. This is expected to

increase in the coming years.

6

Capital

Risk capital is available as a number of new

hedge fund players have entered the market

and raised capital in recent years.

6

Liquidity

Current liquidity is good relative to recent

history, but it is still a bid list driven market

that can see liquidity evaporate for small

niche bonds. This is a less liquid asset class,

especially within mezzanine securities.

4

Financing

Historically, some participants have used

leverage in this strategy (and have sustained

heavy losses). We evaluate this opportunity

only on an unleveraged basis; therefore,

financing should not be an issue.

5

6

We are now Neutral on Structured Credit. We believe the strategy provides adequate opportunities across both legacy residential and commercial-based assets,

but we are cautious because prices have increased off depressed levels and certain securities have longer duration given slower pay-downs. The strategy still is

positive carry but our optimism about the Sharpe ratio in the strategy is tempered by the lack of liquidity in the bonds and the suppressed volatility due to pricing. A

large reassessment of the strategy by real money investors will create large losses when funds sell into a less deep market.



(2,500)

(2,000)

(1,500)

(1,000)

(500)

0

500

1,000

1,500

2,000

2,500

-2%

-2%

-1%

-1%

0%

1%

1%

2%

2%

3%

20

03

: Q

1

20

03

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3

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1

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3

Av

era

ge

Qu

art

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Yie

ld S

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ad

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Me

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ua

rte

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Re

turn

s

Structured Credit Strategy

Dist - Struct Credit

Distressed Ratio



Convertible Arbitrage

Driver of

Strategy

Returns Comments

Attractiveness

Score

(Scale 1 to 10)

Valuations

Discounts have narrowed significantly and

most convertible issues are fairly valued.

Valuations are now higher than the long-

term average.

4

Supply

New issuance has been trending higher but

still lower than long-term historical averages,

and the size of the convertible bond market

is shrinking.

5

Capital

Convertibles are not a crowded space. Only

3% of total hedge fund assets are invested in

Convertibles. Additionally, long-only buyers

have stepped in and are now an important

part of the market.

7

Liquidity

Liquidity provision is an important feature of

the strategy. Prime broker financing that

drives financing liquidity has been good.

6

Financing

Overall leverage levels have risen somewhat

recently for the strategy, however, they are

lower than pre-crisis levels and do not

present imminent risk of financing led

deleveraging.

5

7

We are modestly negative on the strategy as valuations have richened and credit spreads have tightened to mean levels and continue to stay lower. While

convertible bonds have benefited from the grinding lower of yields, the risks to spreads are that it will widen and not contract from here. Recent moves in energy

prices have not benefited the convertible bond markets where a not insignificant percentage of issuers are energy names. Convertibles are an attractive asset class

only when rates are higher than they are currently and while rates are headed higher we do not see it as an imminent development. Convertible bonds as an asset

class will continue to do well on the back of improving equity markets, but we remain concerned about the meager returns to assuming credit risk.



(2,500)

(2,000)

(1,500)

(1,000)

(500)

0

500

1,000

1,500

2,000

2,500

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

20

03

: Q

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Convertible Arbitrage Strategy

Average Median

Quarterly Return

Average Quarterly

High Yield Spread



Corporate Distressed

Driver of

Strategy

Returns Comments

Attractiveness

Score

(Scale 1 to 10)

Valuations

Distressed debt has seen spreads grind down

with the rest of the market. Default rates

have been low for over a decade now and

the ease of refinancing has only made the

investor price distressed debt at very thin

spreads. We do not see this changing in the

short run.

4

Supply

(Defaults and

Restructuring

Opportunities)

The supply of new defaulted debt has fallen

sharply. The default rate remains well below

2%.

3

Capital Capital is plentiful relative to the opportunity

set. 2

Liquidity Strategy does provide liquidity to the market.

The liquidity market is normal. 6

Financing Not an issue. This strategy typically does not

use leverage.

8

Our outlook on Distressed Credit is modestly negative. U.S. default rates are low, suggesting a meager opportunity set for managers. A higher portion of the return

is expected to be delivered from legacy bankruptcy resolutions and late-stage corporate and asset liquidations. Returns in the strategy have been augmented by

increased appetite for illiquidity. We however do see an increase in the opportunity set into mid to late 2015 because of the possibility of restructuring in the

energy sector.



(0.8)

(0.6)

(0.4)

(0.2)

0.0

0.2

0.4

0.6

0.8

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

20

00

: Q

12

00

0 :

Q3

20

01

: Q

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Q3

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: Q

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4 :

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Av

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istr

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ed

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Re

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Distressed Strategy

Returns

Distressed Ratio


INVESTCORP

Global Macro


INVESTCORP Global Macro | 1st Quarter 2015

Leading Indicators

Leading indicators pointing upwards in the U.S. Declining trends in the Eurozone, Japan and China.

US OECD Leading Indicator YoY % Eurozone OECD Leading Indicator YoY %

Source: Bloomberg Source: Bloomberg

Japan OECD Leading Indicator YoY % China OECD Leading Indicator YoY %


-8

-6

-4

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4

6

8

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-4

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2

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6

-5

-4

-3

-2

-1

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1

2

3

4

0

5

10

15

20

25

30



Citi Economic Data Surprise Indices

Economic surprises moderately positive in the Eurozone, Japan and China. Beginning to turn negative in US.

CIti Economic Surprise Index – US Citi Economic Surprise Index – Eurozone


Citi Economic Surprise Index – Japan Citi Economic Surprise Index – China


-200

-150

-100

-50

0

50

100

150

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14

-250

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200


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150


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100

150




Labor Markets

Long-term trend continues to be lower in US unemployment. Average earnings are flat.

US Non-Farm Payroll Monthly Chg '000's US Weekly Jobless Claims '000's


US Unemployment Rate % US Average Hourly Earnings Private Employees – Non-Farm Payroll


-1000

-800

-600

-400

-200

0

200

400

600

Initial Jobless Claims (Left axis)

0

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400

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700

Jan

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Jan

-06

Jan

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Jan

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-09

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Jan

-12

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-13

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-14

Initial Jobless Claims (Left axis)

US Continuing Jobless Claims (Right axis)

0

2

4

6

8

10

12

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5



Labor Markets

Unemployment is still a major problem outside of Germany with Greek unemployment above 25%,

Spanish unemployment near 25% and Italian unemployment increasing to 13%.

Eurozone vs. Germany Unemployment Rate % Eurozone Problem Regions


0

2

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6

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10

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14

Eurozone Unemployment Germany Unemployment

5

10

15

20

25

30

France Unemployment Spain Unemployment

Italy Unemployment Greece Unemployment

Portugal Unemployment



US Housing

Existing home sales have picked up and recovery on track with lower mortgage delinquencies, rising housing starts and new home sales.

US Housing Starts US New Single Family Home Sales


US Existing Home Sales US Mortgage Delinquencies % of Total Loans


90

590

1090

1590

2090

2590

US Housing Starts US Private Housing Building Permits

70

270

470

670

870

1070

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1470

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7

8

US Existing Homes Sales mm=n, SAAR

0

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8

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US Housing

Pace of housing recovery still healthy though the Case Shiller Home Price Index has slowed.

US Case Shiller Home 20 City Home Price Index US NAHB Index


-25

-20

-15

-10

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0

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US Consumer / Retail Sector

US retail sales have stabilized and vehicle sales still strong. Uptrend continues

US Consumer Confidence US Retail Sales (YoY%)


US Domestic Vehicle Sales mm Personal Savings %


0

20

40

60

80

100

120

Conference Board Consumer Confidence

U of Michigan Consumer Confidence

-15

-10

-5

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15

Retail Sales Ex Autos (YoY%) US Retail Sales (YoY%)

0

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18

Domestic Vehicle Sales (mm)

0

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4

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8

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12

Personal Savings % of Disposal Income



Proxies for Business Conditions / Economic Activity

US PMI and Industrial Production have picked up. Europe is slowing after recent positive momentum.

US ISM Manufacturing & Non-Manufacturing PMI US Industrial Production (YoY%)


US Durable Goods New Orders (YoY%) Eurozone Industrial Production (YoY%)


25

30

35

40

45

50

55

60

65

US ISM Manufacturing PMI

US ISM Non Manufacturing PMI

0

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90

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US Industrial Production (YoY%)

US Capacity Utilization % of Total Capacity (Right axis)

-50

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Proxies for Business Conditions / Economic Activity

China business conditions data has weakened over the last quarter

Japan Machine Tool Orders (YoY%) Japan Industrial Production (YoY%)


China Business Fixed Asset Investment (YoY%) China Industrial Production (YoY%)


-150

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Business / Investor Confidence

Business conditions are mixed in the U.S. Regions outside of the U.S. not shown a meaningful pick-up in sentiment

US Business Conditions Surveys ZEW Eurozone Expectations of Economic Growth


IFO Pan Germany Business Expectations Japan Tankan Business Conditions Large Enterprises Manufacturing


-40

-30

-20

-10

0

10

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40

Philly Fed Business Outlook Survey Index

Empire State Manufacturing General Business Conditions

-80

-60

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-60

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Consumer Inflation

Broadly falling inflation globally if you strip out the consumptions tax-related inflation in Japan.

US Consumer Inflation Eurozone Consumer Inflation (YoY%)


China CPI and RPI Inflation (YoY%) Japan Consumer Inflation (YoY%)


-3

-2

-1

0

1

2

3

4

5

6

US CPI Urbun Consumers (YoY%)

US CPI Ex Food & Energy (YoY%)

-1

0

1

2

3

4

5

Eurozone CPI All Items (YoY%)

Eurozone Core Ex Food & Energy (YoY%)

-4

-2

0

2

4

6

8

10

China CPI YoY China RPI (YOY%)

-3

-2

-1

0

1

2

3

4

5

Japan CPI Nationwide YoY%

Japan CPI Nationwide Ex Food and Energy



Producer Price Inflation

Producer price inflation has been contained / is trending down which reflects positively for manufacturer margins.

US PPI Inflation (YoY%) Eurozone PPI Inflation (YoY%)


China PPI Inflation (YoY%)

Source: Bloomberg

-20

-15

-10

-5

0

5

10

15

20

US PPI Finished Goods (YoY%)

US PPI Processing/Intermediate Materials (YoY%)

-25

-20

-15

-10

-5

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10

15

PPI Eurozone Finished Goods (YoY%)

PPI Eurozone Manufacturing (YoY%)

-15

-10

-5

0

5

10

15

20

China PPI (YoY%) China PPI Raw Material Prices (YoY%)



Market Fear Gauge

Volatility still low across equity, FX, and option markets but there have been a few spikes recently.

VIX Volatility Index Merrill Lynch Option Volatility Estimate MOVE


Barclays Swaption Volatility Index Euro-Dollar Volatility Index


0

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290

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0

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Indicators of US Financial Market Stress

Continued improvement in US financial conditions index and low signs of stress in corporate credit and money markets.

US Financial Conditions Index US Corporate Baa / 10-Year Spreads


US Commercial Paper / T-Bill Spread US TED Spread


-14

-12

-10

-8

-6

-4

-2

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0

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Indicators of Non-US Financial Market Stress

EU Financial Conditions Index China 3M Shibor Rate


-12

-10

-8

-6

-4

-2

0

2

0

1

2

3

4

5

6

7



Central Bank Behavior – US

FED has ended quantitative easing but balance sheet holdings of treasury and mortgage bonds are still significant.

FED Purchases of Treasury and Agency MBS Securities US M1 Velocity of Money Supply


US M2 Money Supply US M2 Velocity of Money Supply


0

500

1000

1500

2000

2500

3000

3500

4000

4500

US FED Total Tresasury + Agency Debt and MBS Holdings

0

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4

6

8

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12

0

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4

6

8

10

12

0

0.5

1

1.5

2

2.5


INVESTCORP

Hedge Equities


INVESTCORP Hedge Equities | 1st Quarter 2015

Equities Alpha View

Our views on equity long short strategy is driven by

an analytical framework that seen total returns as

driven from a variety of sources. These sources are

the direction of the broad market markets, the

returns to various style factors or tilts, returns to

different weighting schemes that exploit the

volatility & covariance structure of underlying stock

prices, returns to trading strategies such as

momentum or carry, returns to providing liquidity

that operates on a smaller time scale betting

on reversion to mean and the returns from the

cross dispersion of returns (or stock selection

alpha). These sources of returns represent the

investment universe that equity long short

managers operate in.

We will for ignore the last two sources of return –

the former because it is ephemeral and tied to an

ability to intermediate trades or help

intermediaries lay-off trades and the latter because

it is specific to a fund manager’s trading strategy

and not to the markets themselves- and focus

instead on the return to factors as well as on

dispersion of returns that allow managers to take

active bets on their performance and outperform

the index.

Factor Returns

Since the seminal Fama-French paper it has been

the standard practice to use their three priced

factors in addition to market returns to explain

security returns. If any confirmation was needed on

the importance of this strain of research, the Nobel

committee’s decision to award Eugene Fama one-

third of this year’s economics prize provided one

even if he shared the podium with another

economist who pioneered research on why Fama

was not wholly correct on his efficient market

theory. We will evaluate monthly returns to factors

from a different source- the commercially available

Barra GEM3 (Global Equity Market) long term

model. Fama-French factors and their close cousins

like Barra are not the only way to view the factor

structure of the equity market returns and in the

future we will introduce other models based on

very different pricing kernels. As is always the case,

a long history helps put the more recent numbers

in perspective – even, if in some cases, it is only to

describe the glory days gone by- and explains our

longer term view on factor based investing; the

near term returns provide a context of the

magnitude of returns. We have selected a few

factors for our purposes here to make our case.



Near-term performance of Factors

It is instructive to see the return on pure factors

that have done well in recent memory and link that

to investment themes. Some of the conclusions

continue to be consistent with more fundamental

based views and others not so. The “search for

yield” that has been the stated aim of (and also the

bedrock of the criticism of) QE and its effect on

equity markets is borne out partially; earnings yield

as a factor has explained 3.13% of the return in

excess of the market in 2013 and another 2.59%

this year while its purer cousin- dividend yield has

not losing -0.90% during 2013 while contributing

1.31% in 2014 so far. Size was not an advantage in

2013 and the performance has been erratic so far

this year with large cap stocks underperforming

small cap stocks and there has been persistence in

outperformance- stocks that outperformed in

recent periods have tended to outperform in

subsequent periods with unit exposure to the

factor earning an excess return of 7.58% in 2013

and up 3.90% in 2014. The return to momentum

has mostly good but with a minor hiccup in March

and April of 2014. It paid to be long Beta in 2013

where world equity markets have returned 25%,

but 2014 has been a year where sticking to low

volatility stocks has paid off- Beta, high volatility

and leverage stocks have underperformed.

Sources: Barra, Investcorp

Book to

Price

Dividend

Yield

Earnings

Yield Growth Leverage Liquidity Momentum Size

Size Non-

Linear Beta Volatil ity

Year to Date 0.34% 1.31% 2.59% 1.28% 0.03% 0.37% 3.90% 0.89% 1.80% -2.36% -4.70%

2014:Q4 (Nov.) -0.71% 0.16% 0.38% 0.44% 0.00% 0.27% 0.84% 0.34% 0.05% -0.35% -1.81%

2014:Q3 0.13% -0.24% 0.77% 0.67% -0.42% 0.04% 2.12% 0.59% 0.16% -1.31% -2.32%

2014:Q2 0.10% 0.79% 0.93% -0.09% 0.38% 0.30% 0.36% 0.39% 0.78% -0.13% -0.76%

2014:Q1 0.82% 0.59% 0.48% 0.25% 0.06% -0.24% 0.54% -0.43% 0.80% -0.59% 0.13%

2013 1.12% -0.90% 3.13% 0.47% 0.68% -0.95% 7.58% -1.31% 0.75% 2.38% -2.31%

2013:Q4 0.47% -0.12% 1.01% 0.14% 0.25% -0.28% 1.91% 0.08% 0.06% 0.54% -0.23%

2013: Q3 0.17% -0.38% 0.72% 0.07% 0.08% 0.01% -0.04% -0.29% 0.12% 1.52% 1.11%

2013: Q2 0.57% -0.28% 0.11% 0.36% 0.15% -0.23% 2.73% -0.14% -0.26% 1.87% -2.36%

2013: Q1 -0.10% -0.13% 1.27% -0.10% 0.19% -0.45% 2.81% -0.96% 0.83% -1.53% -0.83%

12 Month Return 0.47% 1.33% 2.57% 1.38% 0.22% 0.24% 4.41% 0.86% 1.99% -2.11% -4.58%

24 month Return (Ann.) 1.01% 0.20% 2.89% 0.82% 0.64% -0.39% 5.42% -0.31% 1.24% 0.66% -3.34%

36 Month Return (Ann.) 0.84% 0.23% 3.10% 0.82% 0.70% -0.14% 4.91% -0.40% 0.94% 0.85% -4.01%

Value Factors Size Factors Volatility



Longer-term factor performance trends

Value Factors

There are three different metrics you can use to identify value stocks in the Barra model –

Book to Value, Earnings Yield and Dividend Yield.

The classic book to price factor has been less consistent since 2007. The charts above have

monthly returns to the factors as well as a six month moving average to smooth out monthly

volatility. It is clear that pre 2007 there were very few 6-month periods where the cumulative

returns were negative. The factor has become far more volatile since then.

In contrast a hedge fund manager focusing on high earnings yield companies (cash earnings,

price to earnings as well as analyst-predicted earnings) have done very well. Hedge fund

managers sticking to high earnings to price stocks have since 2008 not had many poor six

month runs. The post crisis equity markets have rewarded investors looking for yields.

But stocks with high dividend yield have not been consistent and in the recent past have not

added any Alpha to stock portfolios. High dividend yielding stocks did outperform in the flight

to quality post 2008 and the European crisis in 2011, but since then have suffered from

diminishing returns.

Book-to-Price

Source: Barra, Investcorp

Earnings Yield


Dividend Yield


-0.020

-0.015

-0.010

-0.005

0.000

0.005

0.010

0.015

0.020

0.025

De

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Book-to-Price 6 per. Mov. Avg. (Book-to-Price)

-0.03

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0.00

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Earnings Yield 6 per. Mov. Avg. (Earnings Yield)

-0.015

-0.010

-0.005

0.000

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Other Factors

Hedge fund managers with portfolio exposure to momentum have generally performed well

over the long run barring for the periods of market corrections 2000, Q4:2008, and 2009. The

factor exposure continues to earn positive Net return alpha but in two recent months- March

and April 2014 it has not paid to be long momentum. Stated in flow terms the marginal flow of

Dollars in the equity markets is to stocks that have outperformed their peers and to repeat a

cliché there is return chasing in markets and exploiting it has on average been profitable.

The small-cap rally in equity markets stalled in the first two months of this quarter. The equity

premium sections make it clear that this was clearly overdone (where large-cap stocks had

expected risk premiums higher than small-cap stocks in the US) and small-cap does not seem

to be the place to be this year.

Growth names have had positive returns and seen lower month-to-month variations.

A longer-term view of factor returns argues that managers who construct portfolios that are

long fundamentally strong names (earnings yield) or in momentum names have done well. We

continue to be wary of funds investing in stocks that are levered (operational and financial).

Momentum


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INVESTCORP

Credit


INVESTCORP

Credit Strategy View

Overall, we are neutral on the global credit opportunity at this point in the cycle. We would tilt

exposure to thematic opportunities, such as European bank deleveraging, event-credit and

energy. Structured credit is still somewhat dislocated and presents a relatively attractive

opportunity within credit. However, we believe that the risk/reward is more balanced than in

previous quarters and liquidity has deteriorated. In general, we observe a structural drop in

liquidity across credit driven by regulation and smaller dealer balance sheets, which should

affect manager’s trading agility in dislocated markets.

U.S Corporate High Yield

The current price of high-yield and leveraged loan debt are near historical highs. This has been

aided in the past few years by a rally in treasuries, improving corporate fundamentals and a

dramatically improved financing environment. The recent credit sell-off, especially in energy

sensitive credits, has created significant bifurcation, which will likely present opportunities,

once the oil-price driven dust settles. Quietly, energy-related credits grew to almost 20% of US

HY indices, thus becoming a driving force for the asset class in period of dislocation. This is less

so for Europe, where there is very little energy-related exposure in the indices.

New Issuance Remains Robust

While high-yield prices remain near historical highs, overall appetite remains robust ($348

billion YTD vs. approximately $399 billion in 2013). The technical dynamics for U.S. high-

yield remain mixed as investor appetite continues, but the amount of loosely underwritten

paper and the uses for high yield debt are starting to show some strain. The lack of

compensation for additional credit risk clearly shows up in spread differential between new

issue B and CCC bonds. Currently we are near 25 year lows (360 bps currently vs. 511 bps

median over the past 20 years).

However, the bid in the market remains relatively intact at least in the near term. The last

three years were a very strong period for high-yield issuance. In 2013, high-yield issuance

broke the 2012 record via nearly $400 billion in new issuance. Another interesting dynamic

is that the record increase in non US dollar denominated high-yield issuance has continued

in 2014. Most of this increase is coming from Europe where the disintermediation of bank

lending will ultimately change the shape of European landscape. The increase in high-yield

issuance should continue within Europe which should help plant the seeds for the next

stressed credit cycle in Europe. This has ramifications for investing in European credit and

the overall liquidity of the market.

Yield to Worst

Source: J.P. Morgan

Spread between Bonds Rated B and CCC

Source: J.P. Morgan, Markit

High Yield Issuance

Source: J.P. Morgan

Credit | 1st Quarter 2015


INVESTCORP Credit | 1st Quarter 2015

Another warning sign that is not problematic (yet,

but starting to look a bit more troubling) is the

sources and uses of high-yield issuance activity.

The vast majority of activity in recent years has

gone to refinance existing debt and for general

corporate purposes. Debt to support LBO and

acquisition activity still remains well below

2007/2008 levels. Furthermore nearly 100% of the

high-yield issued over the past few years has been

cash pay bonds (versus more risky PIK/Toggle

notes). In summary, the high-yield environment is

relatively stable, albeit with an unattractive

intermediate-term return profile with some

technical and fundamental indicators that have

started to flash warning signs.

New Issue Activity

Source: J.P. Morgan



U.S. Corporate Loans

Similar to high-yield, leveraged loans have a somewhat meager total return profile at this

point in the cycle. Currently, spreads within the asset class are L+446 bps which are below

historical spreads (7 year average spread of L+646 bps). This is even more pronounced in the

context of a yield to maturity (5.5% currently vs. 8.3% -- 7 year average). Anecdotally LBO

multiples are again increasing (some deals are closing at 10x+) and credit standards for

new loan origination is starting to decline. At the same time the new issue loan market

remains very robust. Loan issuance remained robust in 2014 as $450 billion of new issuance

has occurred YTD through November (vs. $620 billion for the same period in 2013). The

recently issued warning by the Federal Reserve on underwriting standards for new loans

supports this view.

Demand for leveraged loans has remained relatively robust in recent months aided by the

resurgence in CLO volumes and the presence of a floating rate structure (in loans versus a

fixed rate structure in bonds). The increase in demand for CLOs shows that demand for

structured loan products is coming back. In 2014, demand for loans, CLOs and floating rate

products (generally) was significant (CLO issuance YTD through November at $123 billion is

well above the 2006 peak of $94 billion).

Overall the demand for leveraged loans remains more robust, however the return profile is

less compelling going forward. Select opportunities may present themselves as the maturity

wall continues to be refinanced over time. However demand from both institutional funds and

CLOs seem to have created a current healthy bid in the market.

CLO Issuance

Source: J.P. Morgan, S&P LCD

New Issue Loan Activity

Source: J.P. Morgan



One aspect that is interesting to note (which has

ramifications for the event driven equity

environment) is the increase in the amount of

loan issuance used for acquisitions. Furthermore

the amount of loan issuance used for re-pricing

and refinancing is down thus far in 2014. Another

interesting data point is the increase in loan

issuance used for dividends.

New Issue Activity

Source: J.P. Morgan



U.S. Corporate Defaults

Defaults for both high yield and leveraged loans remain significantly below long term

averages. There are a number of drivers to the low current default rates including:

significant amount of liquidity in the market (i.e. the ability to refinance), reasonable (but

not burdensome) lending standards, and healthier corporate balance sheets. Note: The Q2

2014 data is skewed due to the large TXU default ($16.6 billion in high yield debt and $19.5

billion in loans).

Excluding TXU, the par weighted default rate for high-yield bonds year-to-date through

November 2014 is 0.6% (issuer weighted default rate is 1.5%). This is well below recent

historical averages (25 year average of ~3.8%). Excluding TXU, the par weighted default rate

for leveraged loans year-to-date through November 2014 is 1.06% (issuer weighted default

rate is 1.5%). This is well below recent historical averages (25 year average of ~3.5%).

Year to date, 25 companies have defaulted totaling $51.6bn, already the fourth highest

volume for a calendar year on record. That said, the YTD total defaulted volume falls to

$15.5bn excluding TXU, which is on pace to be the lowest annual default volume since

2007’s $4.5bn. By comparison, $19.1bn defaulted in full-year 2013 and the record for

default volume was in 2009 when $185bn defaulted. The second and third largest default

volume years were 2001 and 2002 when $64.1bn and $63.4bn defaulted, respectively.

In summary defaults have remained near cyclical lows. Defaults have mainly (ex TXU) been

companies that are smaller in size and are typically competitively disadvantaged. In the

charts below it is evident that loan underwriting standards have clearly loosened. Both

second lien and covenant lite origination are on pace to eclipse last year’s record.

Additionally, the technical picture within high yield is starting to become more ominous.

Both current high yield and leverage loan origination should provide opportunities for the

next corporate distressed cycle. Defaulted credit situations provide an opportunity for one-

off opportunities, but the flow of new/attractively priced investments within the area

should remain somewhat limited over the next 12-24 months. While we do believe concerns

around default risk in the Energy sector are overblown, there is a chance the oil pricing

environment could worsen and lead to acute stress in the sector in 2016/17.

High Yield Bond Default Volume

Source: J.P. Morgan

Leverage Loan Default Volumes

Source: J.P. Morgan, Markit

High Yield Default Rate

Source: J.P. Morgan



European Bank Deleveraging

We view the European bank deleveraging as a strong source of opportunities in credit investing for 2015. European bank assets are estimated at 3x the GDP of the

Eurozone compared to US bank assets at 1x US GDP and Japanese bank assets at 2x GDP. PWC estimates the total face value of non-performing loans (NPLs) across

Europe to be EUR 1.2 trillion, or approximately 3% of banking assets. If we add the other non-core assets that European banks will divest of as they attempt to

cleanse their balance sheets, we can be looking at an increasingly diverse landscape of investment opportunities. Data compiled by Bloomberg suggests that the

total assets available for sale by European banks may be closer to EUR 1.72trillion.

Intense political pressure on banks to boost the European economy by increasing lending, especially to small and medium-sized enterprises, is creating additional

need of fresh capital. Hence, the need to restructure bank balance sheet and sell non-core assets in order to free up capital is only growing. Additionally, most

banks improved earnings, compared to past few years, and increased provisioning means disposals of non-core portfolios are significantly more attractive from a

price perspective.

AQR as a Catalyst

The Asset Quality Review that the ECB completed in November 2014 was a comprehensive assessment of 130 European banks, holding in aggregate approximately

80% of all assets within the EU banking union. 20% of the banks failed and a number passed on the margin. The additional detail on bank balance sheets, the

increased level of new bank capital required ahead of the AQR and the higher loss provisioning will, in our view, accelerate the restructuring in most countries. We

expect transactions in some countries to be far more active than in the past few years. For example, Italian-based transactions are expected to more than double

according to PWC, who also noted the significant size of their non-performing loans. Periphery banks have been particularly slow to write-off NPLs, driven by their

inability to absorb losses. However, indicators point to NPL sales gathering pace in the periphery over recent months, a trend that is likely to continue.



Structured Credit

Our outlook for structured credit going into 2015 is mixed. While the carry generally offered

by the asset class remains relatively attractive, the premium required to bear the illiquidity risk

has shrunk massively.

Structured credit has so far resisted well to the bouts of volatility we observed across other

risky assets primarily due to a supportive technical environment. This is particularly the case

for US Non-Agency Residential Mortgage Backed Securities where negative net issuance and

continued interest from real money investors has so far limited downside risk. However, after

a few years of very strong performance, the asset class no longer offers the same optionality

to improving fundamentals in the US housing market for instance. Much of the good news has

now been priced.

In this context, we forecast the returns for the strategy to be in the high single digits for 2015.

And the new environment suggests that a less directional investment strategy may be more

appropriate going forward. Thankfully, hedge fund managers still find pockets of value in

either more distressed sectors, locked-out mezzanine tranches or securities with embedded

optionality like mispriced monoline wrappers or bonds exposed to putback litigation. Over

recent months, most managers have also deployed a more active short book to hedge

themselves against a higher volatility environment and the risks that the upcoming change in

monetary policy in the US could bring further volatility to securitized assets as well.

This supplements typical duration hedges which are generally implemented by the

credit-focused funds.

Geographically, the recent implementation by the European Central Bank of the Asset Backed

Securities Purchase Plan (ABSPP) has opened new opportunities. The program allows the bank

to purchase senior and guaranteed mezzanine tranches of European ABS on both the primary

and secondary markets for the coming two years in amounts estimated to be between 45 and

70 billion euros. This event has created certain dislocations, for instance between securities

eligible for purchase and other bonds with similar credit characteristics. These opportunities

are well captured by hedge funds and we have increased our exposure to the region to benefit

from this tailwind. This will also support the asset backed market in Europe where spreads

have already compressed significantly but should have further room to go down.

Finally, we stress again that while the current liquidity situation in most structured credit

markets has been satisfying, increased volatility could alter that equilibrium. The new regulatory framework including Dodd-Frank and new capital requirements

under the Basel III program has pushed market makers to scale back dramatically their liquidity providing activities. The effects of this new market structure may

only surface in higher volatility environment but these should definitely not be ignored. Consistent with our view that the market environment will become more

choppy in the first half of 2015, we are keeping our ranking for structured credit strategies at neutral for the coming quarter.

Overview of Yields Across the Credit Spectrum

Source: J.P. Morgan

Source: J.P. Morgan

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Non-Agency Residential Mortgage Backed Securities (RMBS)

The Non-Agency Residential Mortgage Backed Securities market consists of legacy bonds

issued to domestic homeowners in the years preceding the 2008 financial crisis. While this

market is shrinking due to the absence of new issues and a continued paydown of existing

bonds, it remains, at a size of circa $650 billion, a large space for hedge funds to operate

into. These securities also offer extremely different profiles depending on the quality of the

underlying collateral (Prime, Alt-A, Subprime), the various credit tranches available to

investors or the overall structure of the bonds.

This market offers exposure to the credit risk of homeowners with the houses placed as

collateral. Fundamentally, Non-Agency RMBS have profited handsomely over the past three

years from significant improvement in the US housing market, as shown in the chart below.

A stronger US economy, targeted government programs and lower rates have also helped

many borrowers afford their mortgages or refinance into lower-rate mortgages. These

headwinds together with a continued hunt for yield from investors have helped the asset

class rally substantially from its lows.

The top right-hand chart highlights the relative yields across certain sectors of Non-Agency

RMBS and High Yield credit. Yields in Non-Agency bonds can be misleading since the bonds

also benefit from pre-payment or other types of positive convexity. But this still tells a story

of a market that is showing more limited upside going forward.

At current prices, the forward-looking return potential of the asset class seems less

appealing. In addition, the second derivatives of most fundamental metrics to the asset

class are also showing signs of slowing down. For instance, the improvement in defaults

rates observed over the past years seems now to be stalling (as shown in the chart to

the right).

Cash Yields Non-Agency RMBS vs Yield in High Yield

Source: J.P. Morgan

Improvement in default rates stalling

Source: Barclays Research

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JPMorgan Domestic HY



Similarly, the outlook for the US residential real estate market appears more balanced

today as constrained credit creation, limited wage growth and the student loan hangover

continue to limit household formation. The annual return of the Case-Shiller House Price

index peaked at 10.9% in October of last year but has since levelled off to 4.8% in

November of this year. This trend is likely to continue with expected returns for US

housing in the 3-4% range for next year according to consensus.

Finally, as is visible on the bottom right-hand chart, the new issue market in Non-Agency

RMBS remains extremely contained and is primarily driven by the Government Sponsored

Entities (GSEs) credit risk transfer deals. The chart also highlights the nature of these deals

for 2014. Broker/dealers expect $12-14 billion of issuance in these deals for next year. At

this size, this could open interesting opportunities but still remains very much a niche in

the global RMBS space.

Household formation has remained tepid

Source: Housing Vacancy Survey, Haver Analytics, Barclays Research

Home Price Appreciation (HPA) slowing down

Source: CoreLogic, Barclays Research

New Issuance in US Non-Agency RMBS - 2014

Source: Credit Suisse



Commercial Mortgage Backed Securities (CMBS)

The Commercial Mortgage Backed Securities asset class offers exposure to loans backed by

commercial properties. In CMBS, fundamentals have also improved dramatically in

synchrony with the stronger macro-economic data in the US. As shown below, vacancy rates

are falling across the various sectors and the properties operating incomes are rising,

providing further support to the mortgages backing these properties.

But prices are already discounting a positive outcome for the asset class and spreads have

compressed further over the past months. This new framework justifies having a more

opportunistic and tactical approach to investing in the sector. Also, hedging should be a

stronger component of profit & losses over the coming quarters than has been the case in

the past.

Contrary to the situation in Non-Agency RMBS, the new issuance has been vibrant in CMBS.

This helps provide fresh supply to the market to compensate the paydown of legacy assets.

Vacancies are falling slowly

Source: Credit Suisse, REIG, Bureau of Labor Statistics

Spreads have compressed across CMBS conduits

Source: Credit Suisse, Trepp, ACLU, RCA

New Issuance Gaining Traction in CMBS

Source: Credit Suisse



Focus on Europe

We next investigate the quality of the market - primarily credit quality – ignoring what we

think is are significant secondary drivers of return volatility, namely, liquidity and trading

volumes. While anecdotally there are worries about the structure of the market, with banks

allocating lower capital to making markets, providing both the current opportunity of a

lifetime for investors, we do not see the dynamics that drive sharp price collapses due to

liquidations as most investors in the space are non-levered and the capital is provided by

hedge funds with relatively longer and onerous redemption terms. But on the credit side we

have, over the medium-term, seen a significant improvement in the delinquency rate across

both legacy and current vintages. This is true for 30-day and the percentage of first time

delinquencies (60+).

Both measures show an improvement in the underlying borrower fundamentals, as do the

measure of Debt Service coverage ratios across conduit pools. As one would expect the

DSCR are leveling off since 2013, but not very different from 2012 vintage conduit loans.

The improved quality of underlying pools and lack of volatility in economic performance is

reflected in the financing rates and spreads in the CMBS markets especially the 10-year

term rates.

ECB ABS Purchase Plan

The ECB announced in September that it will buy for a period of at least two years senior and guaranteed mezzanine tranches of European ABS on both the

primary and secondary markets. The size of the purchases remains undisclosed. The universe of bonds is limited by the ECB general collateral eligibility

framework, an important criterion of which is the bonds’ eligibility status to repurchase agreements Out of an estimated size of 1200 billons of euros, the

universe of bonds eligible to the ECB’s plan is roughly half. Broker dealers estimate the size of the ECB’s plan to 45- 75 billion euros over the first twelve months.

Breakdown of ABS eligible to ECB ABS Purchase Plan

Source: ECB, Barclays Research


INVESTCORP

Event Driven


INVESTCORP Event Driven | 1st Quarter 2015

Event Driven Equities Strategy View

The market environment is very constructive for event driven strategies. Our thesis is the

culmination of a confluence of factors facing U.S. and multinational corporations today. The

current environment is one where companies are awash in liquidity, but have limited paths to

growth in terms of profitability. Companies are under increasing shareholder pressure to

maximize shareholder value, albeit with dwindling ways to do so organically (i.e., through

increasing revenues and cutting costs).

The increasing pressure within the corporate boardroom, ample liquidity, reasonable equity

valuations, and low borrowing costs is leading to an explosion of event driven opportunities.

This should materialize in many different forms including: operational/financial restructurings,

increased share buybacks, transformative, enhanced shareholder engagement, and accretive

M&A, and returning cash to shareholders (via special and increased recurring dividends.

Merger arbitrage spreads as a standalone strategy is not attractive given the annualized return

of approximately ~5%. However the recent increase in large capitalization deal flow could set

the stage for attractive arbitrage spreads in the coming 12-24 months (given the amount of

capital needed to normalize spreads and the legal/regulatory complexity surrounding large-

scale multinational M&A). Merger activity was strong in 2014 and is expected to continue so as

the event driven opportunity set continues to evolve, propelled by consolidation in healthcare

industry and changing dynamics in the energy sector with steep declines in oil prices. Deal

volumes suggest that 2014 was the strongest year for M&A since 2011. Acquiring companies

around the world continued to outperform the market this quarter, with an average

performance of 5.2 percentage points.

Currently cash balances are near all-time highs for U.S. corporations. Given the opportunity

cost of excess liquidity (cash earning nearly zero percent), companies need to efficiently and

effectively deploy current cash balances and the ongoing cash flow of the business. This is

evaluated in the context of a slow growth macroeconomic environment, very low corporate

interest rates, and margins that may have peaked in recent years.

Sales growth of the S&P 500 has been decelerating in recent years but profit margins have

increased in 2014 and expected to improve further in 2015. Corporate share prices have

recovered and while the macroeconomic picture is not robust, there is some visibility on

customer demand, especially within the U.S. Company management and board of

directors are under increased scrutiny and pressure to deliver returns and they have the means

(see cash balances above) to financially engineer value regardless of recent share

price performance.

Cash & Assets for Non-Financial U.S. Corporations ($T)

Source: Federal Reserve

S&P Sales Growth

Source: Capital IQ, Goldman Sachs

Bottom-Up Consensus Forecast

Source: FactSet, FirstCall, I/B/E/S and GS Global Investment Research

$1.0 $1.0 $1.0

$1.2$1.3

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2010 2011 2012 2013 2014 2015E



Not surprisingly, this has led to a significant increase in shareholder pressure in the form of

public activism. Shareholder activism continues to become more main-stream as companies

pre-emptively use a number of “value-creation levers” to maximize shareholder value. The

focus on shareholder engagement was strong in 2014 with investor activism count at 358

suggesting shareholder activism (as measured by 13D filings) was highest in the past five

years. This is very significant and provides a tailwind to unlocking value in the future by

applying pressure to the current corporate governance structure. Given the dynamics (i.e.,

slow but visible growth, flat margins significant cash and cheap financing); the event

environment should continue to be strong in 2015. Significant focus on maximization of

shareholder value has led to pressure on corporate management. In many cases corporate

management is getting more proactive in terms of enacting shareholder friendly actions. This

is important in that these preemptive measures make it easier for an improvement in

corporate governance and value-enhancement corporate activities.

Since 2009 there is clear evidence of an increase in corporate events that seek to maximize

shareholder value. There has been a marked increase in special dividends over the past five

years. Although corporate buybacks have reduced in count when compared to recent years,

they still make a sizeable number. It is important to remember that these are just one area of

event driven strategies used to maximize shareholder value. Some other popular event types

during the current event cycle include spin-offs or break-up candidates, operational/

management-led restructurings, recapitalizations, tax-driven optimization, litigation and or

regulation resolutions, and privatizations.

Investor Activism (count)

Source: Capital IQ

Special Dividend Announcements (count)

Source: Capital IQ

Corporate Buybacks (count)

Source: Capital IQ

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344358

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As seen in the chart to the right, an index of recent spinoffs or demergers can be very

powerful in terms of increasing or maximizing shareholder returns. Since 2009 the Beacon

Spin-Off Index has nearly tripled in value. It should not be a surprise that management

motivations (i.e., transfer pricing or corporate strategy de-emphasis) can lead to an

underutilized portfolio of assets. Furthermore management’s motivations with regards to

keeping certain business segments can have nothing to do with maximizing shareholder value

(i.e., wanting to manage a larger company).

M&A activity remained robust in 2014 as companies continue to see value through strategic

acquisitions. Since 2009 there has been a clear improvement in M&A transaction volumes.

The lack of growth prospects, very cheap financing, high opportunity cost of an oversized cash

balance (immediate accretion in most cases), and the ability to transform a given business

without committing massive capital (i.e., large capitalization M&A) are driving M&A volumes

of smaller and mid-sized companies. Anecdotally the market has continued to award the

accretive nature of these transactions and many times both the target and the acquirer will

trade up substantially post the announcement. This has significant ramifications for increased

M&A in the coming years. Small-cap deals in 2014 are generating the highest return, with

acquirers closing medium-sized deals with a performance of 5.4 percentage points above the

index, compared to larger deals of over $1 billion averaging a 4 percentage points return.

Large-cap announced deal count at 107 increased considerably from 62 in 2013 due to

heightened M&A activity in the healthcare sector. 2014 saw the highest level (count) of M&A

activity in the past five years. Healthcare M&A activity is expected to remain strong in 2015, in

spite of new treasury regulations that discourage tax inversion deals, as large drug-makers will

buy and sell businesses to control costs and deploy surplus cash. M&A activity in energy sector

may pick up in the next 12-24 months, if oil prices stay at the current depressed levels.

In the distressed event space, we are constructive on the opportunity set as there will be

increased number of restructurings in the energy sector in the wake of significant weakening

in oil prices.

In summary, there are a number of positive tailwinds within both the macroeconomic

environment and corporate sector that have led to resurgence in event driven equity activity.

The opportunity set within event should remain broad-based driven by both increasing

shareholder activism and accretive M&A opportunities. We expect the environment to remain

robust over the next year as companies look for ways to maximize shareholder value.

Beacon Spin-Off Index

Source: Yahoo Finance

$200M – $5B M&A Announced Transactions (count)

Source: Capital IQ

$5B+ M&A Announced Transactions (count)

Source: Capital IQ

251421 402 434 406 462

1,059

1,575 1,784 1,687 1,759

1,815

0

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1,000

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2,500

2009 2010 2011 2012 2013 2014

Small-Cap ($200M-$1B)

Mid-Cap ($1B-$5B)

6168 70

5862

107

0

40

80

120

2009 2010 2011 2012 2013 2014


INVESTCORP

Convertible Arbitrage


INVESTCORP Convertible Arbitrage | 1st Quarter 2015

Convertible Arbitrage Strategy View

In the standard taxonomy of factor types 1, convertible arbitrage hedge funds earn risk premiums for the following factors: asset class risk premiums (residual

equity markets, fixed income), style risk premiums (credit spreads, term structure spreads), strategy risk premiums (Gamma trading) and manager alpha from

security selection, new issue discount and structuring of trades. Most convertible arbitrage portfolios run very low residual equity risk and so we will not

comment on that source of return (or risk). Convertible arbitrage, because of the nature of the trade package (long Convertible bonds and short equities),

attracts fairly attractive financing terms from prime brokers and, in effect, offers levered plays on credit. The term structure spread is lower than long bond

funds because of the nature of the investment universe that tends to be shorter dated paper. Gamma trading P&L is a function of buying volatility cheap and

trading that long realized volatility position to earn more, on the average, than the Theta bleed. Convertible arbitrage participants like to talk about the

opportunity for excess return as a “discount” to fair price; you could equivalently see it (and some managers rightly do) as higher credit risk premium. In terms

of magnitude the largest driver of returns is spreads in the credit markets, followed by “excess” credit spreads as reflected in the discount to theoretical that

has to be harvested through Gamma trading. Investing in convertible bonds also presents the ability to earn “new issue” premium through investing in an issue

at a discount.

A portfolio of unhedged Convertible bonds had a poor fourth quarter bringing year to date returns to 6.42% in the US and when you look at the underlying

drivers it is not difficult to see why it is so. The year to date has seen ten year yields fall, rise and then fall again, on the back of the Fed tightening of monetary

policy first by slowing the rate of large scale asset purchase; has seen credit spreads grind lower and begin to rise in the third and fourth quarters and the 4th

quarter saw returns dominated by idiosyncratic risks in the energy sector. Discounts that were negative when compared to the underlying markets have risen

significantly with a sharp correction in early October.

The rest of this document expands on the sources of risk premium listed above.

Discount to Theoretical (or liquidity premiums)

It is not a mystery that an increase in the liquidity premium would lead contemporaneously

to drawdowns in convertible arbitrage portfolios and vice-versa. These discounts have also

been correlated in the past with an increase in credit spreads that only exacerbates the

drawdowns. The correlation co-efficient is close to 0.64 between the two time series

over the last 11 years. This past quarter saw discounts recover after reaching all-time lows

in April.

It is clear that to understand the return dynamics better, it makes sense to look at both

these drivers independently as well as simultaneously.

Discount to theoretical levels at current levels continue to predict a low return environment

for convertible arbitrage managers as can be seen in the chart to the right, which plots the

1. Briand, R; Nielsen, F and Stefek, D: 2010; Portfolio of Risk premia: a new approach to diversification; CFA Digest

Discount & High Yield Spreads

Source: Bloomberg

-2%

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average 3-month prospective return for the HFRI Convertible arbitrage index and the level of discount or richness/cheapness of convertible bonds.

Current levels of cheapness are close to zero and do presage lower than average 3-month returns. A low discount to theoretical (and increasing from current

levels) meant some drawdowns for the strategy this quarter. A similar pattern in early 2011 (when discounts were below the long term mean and rising) and in

2004, 2005 and 2007 were periods of underperformance.

Expected returns based on past returns are fraught with the risk of ignoring a number of other factors that drive returns. Barring 2011, which was an unduly

volatile period with worries emanating from Europe, all the other periods were periods of excessive leverage and/or shrinking supply. Leverage and supply

dynamics do not exist currently but the search for yield by long only investors with more than 55% of outstanding convertible bonds does explain recent

price dynamics.

High Yield Spreads

Since a significant proportion of the convertible universe is lower rated, you should not be

surprised to find that high yield spreads capture one of the sources of expected returns in

convertible bonds. The Merrill Lynch high yield bond yields are currently around 462 basis

points. This is below the long term mean rates well and has trended mostly down for the

past two years with some local volatility in the recent past. Historically this behavior has

been associated with average to slightly below average returns for convertible arbitrage

index. Any sharp increase in spreads will be painful for the strategy as we saw with a

number of energy names in the last couple of months.

The current low level of high yield spreads- does not compensate assuming of credit risks

adequately. Bond yields have historically been even lower before the crisis but the odds of

going to those levels are low.

Implied vs. Realized Volatility

Realized volatility is a source for any hedged long volatility strategy and convertible arbitrage is no exception. The degree of importance depends on the moneyness

of the options, with at-the-money convertibles profiting the most from any increase in realized volatility (compared to implied volatility). The following chart plots

the cumulative squared returns of the S&P 500 index and you can see short term volatility in the index has been muted over the last few quarters.

The chart at the right uses cumulative squared returns as the measure that reacts fastest to the change in volatility with the slope of the line used to identify

volatility regimes. It is clear that periods when local volatility is high is when Convertible arbitrage managers perform very well. Since the middle of 2010, and

barring for the summer of 2011, the equity market volatility has been muted. The din of opinion on worldwide risk shows up everywhere except in the realized

volatility charts in most developed equity markets. This is reflected in the low levels of VIX that at its current levels is still higher than the realized volatility it

purports to forecast. Gamma trading, the bread and butter of convertible arbitrage strategy, and which relies solely on the volatility of underlying stock prices

has suffered.

Rolling 3-Month HFR Index Return & High Yield Spreads

Source: Bloomberg

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Issuance

New issuance has always been a source of additional return for convertible arbitrage

managers. 2014 has seen 128 deals for 43 Billion annualized which is slightly below the 48

Billion issued in 2013. Issuance of converts is a function both of investment climate, stock

volatility and prevailing interest rates. Issuance of converts in the US in 2013 was around 48

Billion which compares well with the 21.4 Billion raised in all of 2012, 25.2 raised in 2011 and

35.9 raised in 2010. This provides some opportunity for the convertible arbitrage managers to

earn new issuance discounts. While encouraging, we continue to be cautious about the size of

the convert universe, because of redemptions since 2010. This diagram of the flows of

issuance and redemptions of convertible securities paints this dismal picture of the stock of

outstanding convertible securities.

The universe has seen a 36% drop in the number of outstanding issues and amount

outstanding at 59% of the peak in 2007.

Conclusion

We remain underweight convertible arbitrage as a strategy based on these drivers of returns. Credit spreads are a little below mean and represent fair

compensation for assuming credit risk given the low volatility environment and the drop in corporate default rates over the last 10 years with risks on the upside if

the spreads widen. In the short run you could see further contraction of credit spreads, but we do see higher probability for the spreads to rise than to fall further.

The discount to theoretical is negative indicative of some overheating in the convertible markets which should lead to muted returns from this source. Volatility –

realized and implied- has been at cyclical lows arguably because of the unprecedented amount of liquidity in the market and the uptick in both should wash itself

out over the cycle (Gamma trading profits negated by Vega driven price increases), though the near term impact of this is expected to be negative for the strategy.

The issuance calendar is robust and should provide some opportunity for managers participating in them. Convertibles being fair value means that the only logical

argument for going overweight Convertibles is as a credit substitute. The equity call provides an upside for high yield credit investors and the relatively short

duration protects convertible arbitrage portfolios from the risk of rising rates.

Convertible Market Snapshot

Source: Barclays Capital

768804 785 764

806

714688

632

567518 538 518

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INVESTCORP

Fixed Income Relative Value


INVESTCORP Fixed Income Relative Value | 1st Quarter 2015

Fixed Income Relative Value Strategy View

We think of traditional G3 Fixed Income Relative

Value (FIRV) strategy as having five return drivers

and one overriding constraint. The primary source

is the return to risk free overnight cash as captured

by the overnight clearing rates at central banks

such as Federal Funds rate in the US. The

supplementary sources of returns or risk premia

under ideal conditions can be understood as

compensation for the risk of being short an option

of some form. The four such return drivers are

pricing of spreads across market segments which

measure the premium for being short an option to

default, pricing of duration risk which can be seen

as compensation for being short an option to

reinvest at higher rates, pricing of volatility both

explicitly in the derivatives market and implicitly

through Convexity in the curve and the pricing of

liquidity that values the option of being able to

avoid shifting assets in the market when liquidity

preference is high. Fixed income markets are both

incredibly deep and significantly less volatile than

other asset classes such as equity. This means that

the compensation for being short these options is

not very high and to compensate risk capital, the

implementation of these trade structures involves a

copious amount of financing (cash and collateral).

This forms the overriding constraint to articulating

views and exploiting them. Financing in the major

markets is ensured by actions of the central banks

at the core and further transmitted by the financial

sector. The risks due to a collapse in financing are

rare, sudden and have a significant impact. Each of

these sources of returns – spreads, term premiums,

volatility and liquidity provide security/segment

selection opportunities that adds to the return

from exposure to risk premia. Fixed income

markets are very deep but do not necessarily exist

in a world without friction or “technicals”. We will

start by examining publicly available indicators that

capture the opportunity set based on these four

sets of indicators and round it off with what we see

happening in the financing markets.

US Rates

A profound driver of rates in the near future will be

the tightening of monetary policy after nearly 7

years of monetary easing by the Federal Reserve.

The Fed has already commenced the tightening by

tapering the large scale asset purchase program to

zero and putting into place mechanisms to drain

the excess reserves through Reverse Repos and

(possibly) term deposits. 2015 will be the year

when there will be some tightening of rates in the

US and the uncertainty around the timing and

magnitude will exacerbate the volatility we expect

to see especially since a number participant

balance sheets have been built up on the back of

the low realized volatility in rates markets. What

the effect of this tightening will be on rates across

the term structure is not known with certainty

though the subjective market opinion is that this

will lead to a steepening of the curve through both

the expected spot rate channel and through an

increase in volatility (and so term premium). We

made the case last quarter that historically this has

not been the case and we continue to remain

skeptical about this model driven view of the term

structure. Term premium has initially risen in the

US and then trended down during many recent

episodes of Fed tightening. The most obvious

reason why this could be so is that rate rises signal

accelerated economic growth (which is dampened

by the rise in rates reducing demand for credit) and

active management of the variability of economic

conditions should translate into more predictable

monetary conditions. In the recent past behavior of

the ten year rates has been heavily influenced by

demand for duration and we do see this dynamic

have an impact on the shape of the curve.



Spreads

We will look at three broad markets which price risks off the treasury curve – the interbank

unsecured swap market, the market for municipal debt and the agency mortgage markets

to get a sense of the level of attractiveness of the opportunity. Spreads are a pure measure

of expected return for an arbitrage manager for assuming the risk.

USD Swap Rates

Swap spreads are at all-time lows. 5 & 10 year spreads have moved up this year, but still

normalized at levels close to 1 standard deviation below long term averages for the 10 year

point and below that for the 5 year swap rate. The return to this strategy and other such

spread trades are similar to carry trades- borrow in lower rate markets (treasury) and lend

at higher rate markets (swap) – we continue to hold that the current returns do not justify

levering up this trade and taking on the risk of an increase in spreads. The 10 year point is a

bit of a conundrum since it has moved lesser than the 5 year point just like the 10 year

spreads in the treasury markets.

5-year Swap Spreads

Source: Bloomberg

10-year Swap Spreads

Source: Bloomberg

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SIFMA LIBOR Ratio SIFMA Swap Ratio Mortgage 30-Year Spreads (Treasury)

Source: Bloomberg Source: Bloomberg Source: Bloomberg

The picture from SIFMA swaps is not very

encouraging either. The ratio that represents both

risks of default as well as tax benefits of investing in

municipal paper is unusually low. While it has

improved from its historical lows, it is still well

below its long term average. Managers can go short

and long the spread, but the ratio is more volatile

than it seems because of the low interest rate

environment we are in. The absolute spreads are

profitable only with very large notional exposure to

these spreads with its associated drawbacks.

The municipal market rate – swap ratio is below its

-1 historical Standard Deviation. At current levels

of 17, it provides a cheap option to play for

increase in municipal rates as a ratio of swap rates.

The rewards for taking on mortgage risks

(prepayment primarily) have improved slightly

over the year, and accelerated this quarter with

the rest of the fixed income markets. Mortgages

are typically the canary in the coal mine for market

disruptions but we did not see convexity hedges in

the mortgage world drive the sharp moves in

October. You will recall the spike we saw in May

2013 precipitated by the leveraging up by

Mortgage REITs has since dissipated (just as they

have not built back their holdings and the spreads

are less than – 1 standard deviation away from

their long term mean. In absolute terms the

spreads are miniscule and represent inadequate

compensation for the risk being assumed

especially in an asset that has negative convexity.

The spread reflects the collapse in volatility in

most asset classes.

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Duration Exposure

In principle, term structure of default risk free interest rates can be decomposed into three

components – expectations of future spot rates, the return for assuming the uncertainty of

the path of future spot rates (Duration premium) and the difference between time average

and ensemble average of per period rates (Convexity premium or drag). We will for our

purposes here focus on the Duration risk as captured by the 5y-10y spread in the swap

curve. The spread between the two rates is stripped off the market expectations of spot

rates in the near term (who has point estimates of expected spot rates 5 years ahead) – and

represents the (unscaled) market price of risk.

The term premium in the swap markets has collapsed through 2014 and showed some small

recovery in mid-October and is back at levels we saw in 2012 and last in 2005 before the

great bond market “conundrum” which were driven by conditions similar to what is driving

markets today. Typically, FIRV managers are partial to positive “carry trades” and so prefer

steepeners to flatteners; the curve has flattened this quarter.

Convexity Risk

We measure the degree of convexity or curvature by looking at 3 relatively liquid parts of

the swap curve- the 5, 10 and 20 year points. The spread fell sharply in June 2013 (or 10

year rates sold off more than 5 or 20 year rates) but has since recovered. The current level

of spreads makes it unattractive to trade butterflies.

The trading of convexity (like Gamma trading in options markets) requires an increase in

market volatility levels and the fall in volatility in all asset classes including fixed income has

not been conducive for selling volatility. The realized volatility that had increased largely on

the speculation about the timing of the tapering of Federal Reserve’s QE program last year

and anecdotally because of deleveraging in some parts of the asset markets where the

marginal investor was levered (such as mortgages) has since retouched historical lows.

Lower levels of volatility are bad for FIRV managers who are long convexity and who will

trade this to eke out a return.

5y 10y Term Spread

Source: Bloomberg

5 10 20 Fly

Source: Bloomberg

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5- 10- 20 Fly Mean + 1 SD - 1 SD



Liquidity

A classic provision of liquidity trade in the FIRV space is trading the spread between on-the-run

issues and off-the-run issues. This spread has been on a secular decline and does not provide the

opportunity that it provided a decade ago. The rise in liquidity premium we observed last year has

since trended down the 2014. The spread is currently 1 standard deviation away from the mean and

does not provide adequate compensation for the risk assumed.

The widening of some of the spreads does represent an increase in liquidity premium, but the

simpler FIRV trades such as selling the on-the-run treasury and buying off-the run is no longer

profitable for the amount of volatility in the spreads.

10-Year Swap Volatility Barclays Swaption Merrill Rate Implied Vol Index

Source: Bloomberg Source: Bloomberg Source: Bloomberg

Volatility in the rates markets has collapsed over

the year and this ….

… is reflected in the derivatives market both

in swaptions …

… and Treasury option markets.

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US On-the-run / Off-the-run Spread

Source: Bloomberg

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Financing Risk

There are two different time series that we will use to examine the financing conditions in

addition to indices created by Citibank & Goldman Sachs. The first is the conditions in the

market for collateralized lending (Repos) against general fungible collateral; and this

presents a picture of funding conditions in the largely non-bank financial intermediary

markets and another the LIBOR OIS spread for condition in the unsecured short term

interbank funding market. In both cases we will compare this to a fed fund proxy (effective

Fed Funds rate in the case of Repos and OIS swap rates in the case of LIBOR).

The general collateral market had been under some stress with issues arising from the

availability of collateral following QE3. Repo rates are close to zero in line with effective fed

funds rate and now trade at a 9 bps above fed funds rates.

The LIBOR OIS spread is at historical low levels in large measure because of the liquidity

injected by the Federal Reserve and the quelling of fears about bank failures in the US.

Given the high levels of excess bank reserves and the improvement in the quality of bank

balance sheets it is not surprising that this one indicator from the dog days of the 2007/08

crisis is calm.

Fed Funds Less Repo

Source: Bloomberg

LIBOR – OIS USD

Source: Bloomberg

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Market liquidity indicators – such as the Citi Market Liquidity Index show continued

improvement in the financial liquidity conditions. The indicator ticked up (signaling poorer

liquidity) on the back of some short term stress in the most liquid parts of the fixed income

markets- agency, 5 year and 10 year points on the term structure. The large sell-off in rates

markets in June 2013 is now just a little blip in most of the indicators. The one bright spot is

the rise in FX volatility which presages increase in volatility in rates markets.

Conclusion

Fixed Income Relative Value has been a mixed bag and almost all of it is a reflection of

the money market conditions and the unprecedented success of both forward guidance and

QE. The strategy needs volatility – both realized and implied in the options markets – to

thrive. Interest rates in the US (as in Japan since 1990) have been low and basis point

volatility in rates markets have gone lognormal. This clearly implies that the volatility should

pick up only once rates rise in the markets and till such time classic arbitrage trades are not

going to be profitable enough for assuming the risk of liquidity or drying up of financing.

Expected volatility brings down implied volatility levels in options making selling options as a

trade unprofitable; it also brings down expected term spreads and anticipation of profits

both from assuming term structure risk and trades involving convexity. The overriding

constraint to FIRV- availability of financing especially collateralized lending- was affected by

large scale asset purchases of Fed but has now been remedied with the Reverse repo

facility. We see the strategy becoming interesting as volatility picks up with the hike in Fed

Funds rate in the US, though Japan and Europe both remain uninteresting for pure relative

value curve traders.

Citigroup US Market Liquidity Index

Source: Bloomberg

J.P. Morgan G-7 FX Volatility Index

Source: Bloomberg

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-03

Jan

-04

Jan

-05

Jan

-06

Jan

-07

Jan

-08

Jan

-09

Jan

-10

Jan

-11

Jan

-12

Jan

-13

Jan

-14

0

5

10

15

20

25

30

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Jan

-05

Jan

-06

Jan

-07

Jan

-08

Jan

-09

Jan

-10

Jan

-11

Jan

-12

Jan

-13

Jan

-14


INVESTCORP

Disclosure

Research

Investcorp conducts proprietary research. The information contained herein is being provided on a confidential basis and is for informational purposes only. This document may not be

reproduced in whole or in part, and may not be delivered to any person without the prior written consent of Investcorp. Proprietary research is developed, produced, and prepared by

Investcorp Investment Advisers LLC and Investcorp Investment Advisers Limited.

The hypothetical models used to describe the portfolios and indices contained herein were created for illustrative purposes only and there can be no assurance that investment objectives

of an actual model will be achieved and actual investment results of such a model may vary substantially. The returns are hypothetical and were achieved by means of application of

model(s) developed and applied with the benefit of hindsight. The returns do not reflect actual trading of any portfolio or index. The hypothetical model portfolio or index returns do not

reflect the impact of factors that may have adversely affected Investcorp’s decision-making process if actual investments had been made at that time.

The hypothetical models may not reflect fees and expenses at the portfolio level, and can only incorporate estimates of historical transaction costs. The analyses provided rely on

proprietary models which are based on a certain set of parameters and assumptions and do not reflect actual investment experiences. Analyses based on other models or different

assumptions may yield different results. All views and opinions contained herein are current as of the date of this document but subject to change. Investcorp has no obligation to update

the information contained in this document.

Risk

The analyses provided herein are done using proprietary models based on a certain set of parameters and assumptions. Information used to generate the model results are from third-

party sources, including hedge fund managers, the prime brokers, and/or administrators, that we believe to be reliable but we make no warranty as to accuracy of such information. We

also make use of third-party providers of risk analytics and pricing tools in our proprietary models to generate the information provided herein. We make no warranty as to the reliability

of such third-party tools nor make any representation as to the effectiveness of such tools in measuring risks or prices.

This analysis is being prepared by Investcorp and the views expressed are those of Investcorp only. Analyses based on other models or different assumptions may yield different results.

There are many ways to measure risks in various asset classes and strategies. While we believe that the information contained herein is a reasonable representation of managing risks, we

make no representation that the information contained herein is the correct view of how risks should be managed or measured.

Additional Disclaimer

The information contained in this document may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that reflect our current

views with respect to, among other things, future financial and business performance events, strategies and expectations. We generally identify forward-looking statements by

terminology such as “outlook,” “believe,” “expect,” “potential,” “continue,” “may,” “will,” “should,” “seeks,” “approximately,” “predicts,” “intends,” “plans,” “estimates,” “anticipates” or

the negative version of those words or other comparable words. Any forward-looking statements contained in this document are based upon the historical performance and market

information, and on our current plans, estimates and expectations. The inclusion of this forward-looking information should not be regarded as a representation by us or any other person

that the future plans, estimates or expectations contemplated by us will be achieved.

Such forward-looking statements are subject to various risks and uncertainties, including but not limited to global and domestic market and business conditions, our ability to successfully

compete for fund investors, investment opportunities and talent, successful execution of our business and growth strategies, our ability to successfully manage conflicts of interest, and

tax and other regulatory factors relevant to our structure and status as a public company, as well as assumptions relating to our operations, financial results, financial condition, business

prospects, growth strategy and liquidity. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, our actual results may

vary materially from those indicated in these statements.

These factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements and risks that are included in this document and any relevant

offering materials. Any forward-looking statements, views, and opinions contained in this document are current as of the date of this document but subject to change. We do not

undertake any obligation to update or review any forward-looking statement, views, and opinions, whether as a result of new information, future developments or otherwise.

The reports or commentaries that constitute part of this document may rely on public information and sources. Information used to generate model results, reports or commentaries are

from third-party or public sources that we believe to be reliable but we make no warranty as to accuracy of such information. Data from hedge fund indices reflect returns net of fees and

expenses. Databases are used to gather qualitative and quantitative information from a variety of sources to allow paid subscribers to conduct analysis of managers, indices and their

related performance.

Investcorp Hedge Funds Environment Report | 1st Quarter 2015

INVESTCORP Hedge Funds Environment Report | 2nd Quarter 2014

Investcorp

280 Park Avenue, 37th Floor

New York, NY 10017

(212)-599-4700

[email protected]

INVESTCORP

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