Deep Dive: Reverse Convertible Structured Notes

Reverse convertible structured notes represent a complex but potentially rewarding corner of the fixed income market, combining elements of bonds and equity options to create high-yielding debt securities that can deliver "double digits coupons." As explained by Kris Konrad from Piton Investment Management, we explore the mechanics of these income-focused instruments; why they can be extremely attractive when volatility is elevated, and how investors can harness their unique risk-reward characteristics—including upfront price buffers and regular coupon streams—while navigating the binary risks that come with barrier-based structures.

Q1. What are reverse convertible structured notes specifically?

A reverse convertible structure note is a complex financial product issued by large financial institutions, and these combine the elements of both bonds and equity options in order to create high yielding debt securities. These types of securities are also commonly known as "Income Notes."

Definition & Structure:

• Structured financial product that combines bonds and equity options

• Creates high yielding debt security from large financial institutions

• Commonly known as "Income Notes"

• Designed to generate above-average yield from equity exposures

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Q2. Why has Piton chosen to focus on reverse convertible structures?

We are a fixed income shop. We create and manage yield based SMAs for our clients. Although there are many types and flavors of structured notes available in today's marketplace, we felt sticking to income notes fit the best within our portfolio allocation matrix since yield is generally the primary objective of our clients.

Strategic Focus:

• Aligns with Piton's fixed income core business

• Fits within yield-based SMA portfolio allocations

• Matches primary objective of yield-seeking clients

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Q3. Could you explain the mechanics of how reverse convertibles work in simple terms?

When investing in these types of securities, you, the investor, are essentially lending money to the issuer while also simultaneously selling them puts, and in some cases calls as well, on an underlying stock or index. In return for all of these actions, the security pays you, the investor, a regular stream of coupon payments while the security’s value is based on the price performance of a reference or underlying stock or index. As long as the price performance stays above a predefined downside level, the investor will receive 100% of their principal back at maturity.

For instance, if we own an income note that has 30% soft protection, and at maturity, its underlying security has gone down only 25% during the life of that note, then that note will automatically mature at 100 cents on the dollar. Conversely, if that underlying security is down 35% at maturity, so 5% more than the stated downside protection barrier, then the note will automatically mature at 65 cents on the dollar or down the entire 35% matching that of the underlying security.

There are also some other features that can be thrown into the equation as well - things like note call features or contingencies around whether the note pays a coupon or not. These additional features are typically added in order to juice yields on these notes even further. But obviously they also change the risk dynamics.

How They Work:

• Investors are essentially lending the issuer money while simultaneously selling puts (and sometimes calls as well) on an underlying stock orindex

• Regular, periodic coupon payments

• Principal protection above a pre-defined downside barrier

• If barrier is breached, note value performance matches that of the underlying's price performance

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Q4. What market conditions tend to be most favorable for reverse convertible notes?

When structuring and executing new notes, the most favorable market condition is usually one marked by elevated volatility. The higher the perceived implied volatility priced into a stock or index’s listed options, the more those options can be typically sold for. And it is the sale of these options that produces the actual cash flows that are then paid to the note investor in the form of regular coupon payments. Therefore, in markets where volatility is elevated, yields tend to be noticeably higher on income notes. Also, if that environment means an overall lower pricing of the market in general, then that initial strike on new notes as they're executed will likely also be lower, which is what will dictate the performance of the note once it is issued.

Optimal Market Conditions:

• Environments with elevated volatility can be themost favorable

• Higher implied volatility allows options to be sold at better prices

• Option sales generate the cashflows that fund the note coupon payments

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Q5. What are the primary risk and reward characteristics of reverse convertibles?

The primary reward is owning a security that pays an above average yield and is not typically impacted by changes in interest rates like most investment grade credit typically is. Most of the structures that we create for our clients have coupons well into the double digits for only a two to three year note. And on top of that, you receive an upfront price buffer on the underline.

In return, on the risk side, you are taking on a binary risk of the notes barrier. In other words, if the underlying is above it at maturity, you receive par back plus all of your coupons that have been paid to you along the way. But if the underlying falls below the barrier and the note breaches, then you have to absorb a pretty hefty mark-to-market loss at maturity. But keep in mind, you still receive all your coupons along the way, which can defuse a big portion of the realized mark-to-market loss incurred when a note matures while it's in breach status, or in other words, when the underlying is below the barrier at maturity.

And then lastly, like all bank issued debt, at the end of the day, you are also taking on credit risk of the issuer. We try to mitigate this risk by only buying structures from the highest-rated financial institutions, and then still diversifying our issuer exposure as best we can.

Risk & Reward Profile:

• Rewards: At times, double-digit coupons, shorter maturities than other high yielding debt securities, upfront price buffers, minimal interest rate sensitivity

• Primary risk: Binary barrier breach resulting in either full return of principal, or full loss participation on the underlying price performance

• Coupons received along do provide significant boost to total return profile

• Credit risk from note issuer mitigated through highest-rated institutions and issuer diversification

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Disclaimer

Structured Notes are complex products and are not suitable for all investors. Before making any investment decision, you should carefully consider the investment objectives, risks, charges, and expenses before investing. This and other important information are included in the Structured Notes’ offering documents. The investment strategies discussed are strictly for informational purposes and should not be construed as a recommendation to buy or sell. For further information regarding Piton Investment Management, LP, please see our Form ADV at https://adviserinfo.sec.gov/firm/summary/282517