Understanding Structured Notes with Kris Konrad of Piton Investment Management

Kris Konrad of Piton Investment Management shares his expertise on structured notes, explaining how these instruments generate cash flows through option sales rather than traditional balance sheet backing, and how they can enhance portfolio yields while providing defined levels of principal protection. Join us as Kris breaks down the mechanics, varieties, and strategic applications of these increasingly popular investment vehicles.

Q1. For listeners who are new to this space, what exactly are structured notes? How do structured notes differ from traditional fixed income investments like bonds?

Structured notes are customized financial products issued by large financial institutions. They combine the use of debt instruments with embedded options or derivatives. They are different from traditional bond and fixed income investments in that, unlike those traditional investments that generally have cash flows that are supported or backed by some entity's balance sheet, such as the U.S. government, municipalities, or corporations, or have their cash flows that are passed through from the obligor to obligee, in the case of mortgage backed securities, structured notes differ in that they generate their cash flows primarily from the sale of other investment products, which are options. They are generally linked to the performance of another reference security or index, and typically come with state levels of principal protection. That is really the key component of structured notes, protective investing. That protection applies so long as the embedded options that are sold within the structure are out of the money when the security matures.

Structured Notes Basics:

• Customized financial products with embedded options

• Cash flows from option sales, not entity balance sheets

• Principal protection based on option performance

• Different from traditional government/corporate bonds

Q2. What are the main categories or types of structured notes available in today's market?

There are many different types and flavors of structured notes sold in today's marketplace. Some are very straightforward, and then some are quite complex. At Piton, we primarily focus on structured notes that provide income since that fits nicely with our core business of providing yield to our clients.

Types of Structured Notes:

• Range from simple to complex varieties with different risk profiles

• Focus on income-generating notes that provide regular cash flows

• Aligned with yield-focused business objectives for client portfolios

• Various structures tailored to different market conditions and investor needs

Q3. Could you walk us through the basic mechanics of how structured notes work?

I will walk you through the basic mechanics of a structured income note. These are structured around a reference security or several securities. This could be individual companies, like Apple, Google, or Boeing, for instance, or market indices like the S&P 500 or the NASDAQ 100. These notes will generally pay a regular coupon, typically either quarterly or monthly, and be valued based on the price performance of the underlying security. The note will also have a stated level of principal protection, known as a protection barrier, meaning as long as the reference security does not decline by more than the barrier amount, the note holder will receive all their principal backend maturity, plus the coupons earned over the life of the security. But if the reference security declines more than the stated protection barrier, the note will mature down the same amount as the reference security. So, for example, if you own a two-year Google income note that has 30% protection and in two years, when that note matures, Google is down 25%, you'll receive a hundred percent of your principal back at maturity. Now, conversely, if Google is down 40% two years from now, this note will mature at 60 cents on the dollar, or down 40% from where I bought it. In return for this binary risk, the note will pay approximately today at 8.75 annual coupon for two years, and this is a lot more than the half a percent of Google Stock currently pays in terms of dividend yield, and it's even more than the 5% Google's 35 year corporate debt yields.

Structured Notes Mechanics:

• Regular coupon payments (monthly/quarterly) with defined protection barriers

• Binary risk with higher potential yields than traditional investments

• Principal return based on reference security performance relative to protection threshold

Q4. What role do structured notes typically play in a diversified investment portfolio?

As we covered in the previous question, structured income notes play a large role in yield enhancement. The yields we are able to generate in customized note structures generally are well into the double digits, especially on names that have high volatility associated with them. In the end, it's the sale of the options on the underlying name that generates the cash flows for the note. This, of course, comes with higher risks than our typical investment grade portfolios do, but we have clients that are willing to allocate portions of their portfolios here in order to materially increase their overall portfolio yield.

Portfolio Role of Structured Notes:

• Double-digit yield enhancement for overall portfolio returns

• Strategic allocation component for income-seeking investors

• Higher risk profile than traditional investment grade options

• Returns generated from underlying option sales and volatility

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Disclaimer

Investing in securities, including structured notes, involves risk of loss. 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.